A New Federal Reserve Initiative Could Keep State And Local Governments Funded Through The Pandemic
The Fed’s new Municipal Liquidity Facility can be a necessary financial lifeline to states facing a cash crunch -- but only if they use it properly and completely.
This research and analysis is part of our Discourse series. Discourse is a collaboration between The Appeal, The Justice Collaborative Institute, and Data For Progress. Its mission is to provide expert commentary and rigorous, pragmatic research especially for public officials, reporters, advocates, and scholars. The Appeal and The Justice Collaborative Institute are editorially independent projects of The Justice Collaborative.
Cities, counties, and states face an immediate problem — they require money to fund coronavirus-response services at the same time as tax revenues are falling because of the economic downturn. While many local governments would issue bonds to cover their costs, the municipal bond market is experiencing high volatility, making it difficult to sell on the open market. In essence, states and local governments are facing a cash crunch at the very moment people are relying on them to provide essential services.
In early April the Federal Reserve Board announced what promises to be a viable solution: the Municipal Liquidity Facility (MLF) — an unprecedented initiative to extend emergency funding directly to state and local governments, allowing them to avoid the roiled open market. Then in late April, the Fed announced it had improved the terms from its previous announcement and would purchase $500 billion in short-term notes directly from states, counties, and cities. By providing instant funding for local pandemic responses, the MLF has the potential to be a game-changer by helping municipalities fund their own initiatives to respond to their own local needs.
If this all sounds novel, it is because it is. The MLF is a form of community quantitative easing — buying bonds to inject money into local economies — provided by the Federal Reserve. The MLF can be a necessary financial lifeline to states, but only if they use it properly and completely.
Therein lies the challenges to the MLF. Because of unfamiliarity, the very idea may be intimidating and even off-putting to many local political and financial officers, which may in turn lead to underuse. But local officials need to keep pressure on the Fed to continue to expand the MLF, including more localities and dropping needless restrictions. This report aims to demystify the MLF, encourage its use, and provide a guide for states, cities, and others who wish to see this country climb out of the public health and finance hole dug by the coronavirus.
The MLF Now: Key Current Provisions And Improvements
The MLF is authorized by Section 13(3) of the Federal Reserve Act of 1913, which provides the Federal Reserve emergency lending authority to deal with exigent circumstances. In response to the pandemic, the Fed set up the MLF to be administered by the Federal Reserve Bank of New York (FRBNY) located just off Wall Street.
Suggested Improvement: The MLF should be distributed across all the Regional Federal Reserve Banks, not concentrated solely in the FRBNY. This will enable the Fed to operate the new MLF far more efficiently and effectively. Right now, states and cities are serving as de facto federal agencies because of the failed response of the federal government. In so doing, they require full, efficient, and locally responsive federal funding, which is better done through regional banks.
Currently, the MLF permits the Fed to purchase bonds directly from states and cities rather than forcing local governments to sell them on the open market. This process has the advantage of quickly providing states with needed funding.
Suggested Improvement: Right now, the MLF terms include a clause that permits the Fed to assess a “penalty rate” when making these purchases. Traditionally, such a provision is meant to discourage risky borrowing practices. But here, the penalty is in opposition to the purpose of the MLF as assistance to entities struggling through no fault of their own, and should be removed.
MLF terms set the months-to-maturity on eligible notes at 36 months, increased from the original 24 months. In other words, MLF loans are now good for up to three years. It seems likely this will be extended to five years or more by the summer. The Fed envisions that states and cities will use the MLF to cover shortfalls in revenue that normally derive from property taxes, sales taxes, and similar revenue-generating sources — sources that the pandemic has temporarily cut off. But the MLF currently requires that all notes purchased under its program be “investment grade.” And the MLF stipulates both prior bond ratings histories and minimum rating agency ratings for which eligible notes must qualify.
Suggested Improvement: Normally, ratings requirements may have a sound financial rationale. But rating requirements and histories will prevent many places that need the money from using the MLF, and they should be removed. First, there is no reason to assume states and cities unable to cover relief costs right now will be unable to return to their pre-coronavirus conditions if financially enabled to get there. And second, some cities with lower bond ratings are the ones most in need. It is nonsensical, counterproductive, and cruel to leave those cities and municipalities out. States, cities, and all who wish to end the present pandemic must unrelentingly press the Fed to remove the new reference to bond ratings and rating agencies.
The current form of the MLF limits eligible issuers to (a) all U.S. states and the District of Columbia; (b) all U.S. counties with populations exceeding 500,000; and (c) all U.S. cities with populations exceeding 250,000. Originally, the program was limited to cities of one million residents or more and counties of two million or more, but was expanded following criticism that it left out far too many areas, including some of those hit hardest by the coronavirus. An improvement indeed, but the Fed could still do better.
The MLF is also open to interstate compacts among any two or more states. This is significant because it suggests that the Fed recognizes that many states and cities are beginning to forge multi-state unions to address collectively those pandemic-caused collective action problems, such as having to compete with one another for scarce medical and protective equipment, that federal action is meant to solve in our constitutional order.
Suggested Improvement: The new April 27 Term Sheet says nothing about Tribes or Territories. This is a glaring, and indeed scandalous, omission. All who seek to benefit from the MLF must unify and press the Fed to remedy this omission. This is a matter of justice, efficiency, and congressionally enacted statutory requirement alike.
The Next MLF: Likely — and Necessary — Easing Ahead
Because the April 27 MLF Term Sheet provides even more than the April 9 sheet, it is reasonable to expect that terms will continue to ease should the national pandemic continue. Local governments should keep pushing for further easing, and there are positive signs that this will be successful. First, Chairman Powell and the Fed Board of Governors have publicly encouraged a flexible interpretation of all conditional language found in the MLF’s Term Sheet. They have also repeatedly stated that they will be monitoring the municipal debt markets for signs of resumed volatility and dysfunction, with an eye to more intervention if necessary. Combined with easing already done to the Term Sheet as described above, these amount to assurances that the MLF is a work in progress whose scope can in theory expand if and as the need for it expands.
Second, bond market and public finance experts have called on the Fed to purchase state and municipal debt with maturities not only in excess of traditional 6-month and 12-month durations, as well as first crack at 24-month durations, but also in excess of the 36-month duration. The Fed has done nothing to discourage such calls. Most commentators anticipate upward of five-year state and municipal debt to find its way onto the MLF balance sheet before the MLF completes its mission.
The takeaway is that state, county and city governments should take advantage of the existing MLF terms and continue to push for more favorable ones.
A Three-Phase Game Plan for States and Their Subdivisions
In light of the above, states, their subdivisions, and any created compacts should be planning for both the use and the further expansion of the newly eased MLF. This MLF, again, is unprecedented — the Fed is improvising right now. What states and cities do in response to the improvisation will thus be important in determining what shape the MLF takes as it unfolds — and will significantly impact the ability of governments to respond to this crisis. The following three-phase plan is proposed with this in mind.
Phase One: Immediate Quantitative Legislative & Executive Sessions. All state governors and legislatures, as well as their county and city counterparts, should go into emergency session at once, virtually if need be, to determine how much funding to seek from the MLF. Additionally, they must all open regular channels of communication both with the Federal Reserve Bank of New York (FRBNY), which will administer the MLF, and with their regional Federal Reserve Banks, all of which have public affairs offices for the purpose. Part of this dialogue should include pushing the Fed to expand the program, as discussed above, beyond the FRBNY to other regional banks.
Phase Two: Subsequent Allocative Sessions. Once all Phase One decisions have been reached, states and their subdivisions must gather information, testimony, advice and all other deliberative inputs necessary to make sensible allocation decisions with respect to the new funding that will be incoming from the MLF. Crucially, some states, subdivisions, and compacts will likely see advantages in establishing state-wide or interstate coordinating bodies through which States and all relevant subdivisions can plan together in issuing eligible notes and directing resultant funds. Additionally, some states and subdivisions will benefit from developing such coordinating bodies into full local public banks, which will not only help store and disburse funds, but can also help lever them into additional monies, as well as ensure all state residents have access to banking and payment services.
Phase Three. Further Easing-Demand or Envelope-Pushing Sessions. Phase Three will entail pressing the Fed to ease even further the terms of the MLF Term Sheet in the ways discussed above, if not more. States should demand that no penalty rates be assessed or rating requirements imposed, that the Fed be authorized to purchase state and municipal paper of longer maturity than 36 months, even up to 5 year notes as many analysts predict — or that a rollover option be made explicit — and that tribes and territories not be excluded.
Officials Should Take Full Advantage of This Opportunity
This new MLF, if properly shaped, could represent a unique and potent source of municipal service funding, including for specific programs like housing, emergency first responders corps and wellness check programs, neighborhood non-profit investments, paid and sick leave, state-level basic incomes, comprehensive healthcare — all localized care economies with real resources. All states, cities, and communities with budget shortfalls should apply for MLF funding so as to be able to sustain or start critical programs. Local officials should take full advantage of the opportunity, including pushing the Fed to do more. If they do, MLF will be a key ingredient in helping states dig themselves out of the financial crater caused by the coronavirus.
Robert Hockett is a law professor at Cornell Law School. His principal teaching, research, and writing interests lie in the fields of organizational, financial, and monetary law and economics in both their positive and normative, as well as their national and transnational, dimensions. His guiding concern in these fields is with the legal and institutional prerequisites to a just, prosperous, and sustainable economic order.