Robert McCauley on Bond Market Crises and the International Lender of Last Resort

Robert McCauley is a senior fellow at the Global Development Policy Center at Boston University, an Associate Member of the Faculty of History at the University of Oxford, and was formerly at the Bank of International Settlements for 25 years and the New York Federal Reserve Bank for 14 years. Robert is also a returning guest to the show, and he rejoins Macro Musings to talk about his recent article titled, *Bond Market Crisis and the International Lender of Last Resort* David and Robert also discuss the basics of a bond market run, the policy reaction and implications of the 2020 “Dash for Cash”, the possible concerns with corporate bond facilities, and a lot more.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Bob, welcome back to the program.

Robert McCauley: I'm glad to be back, David.

Beckworth: It's great to have you on. We're going to discuss this amazing article that you've written. It was really useful for me, Bob, because it forced me to go back to March, 2020 and to think about why the Fed intervened in corporate bond markets, which was a first, as you note in your paper, but also how it did it and moving forward, what's the best approach. But before we jump into that article, and I think it's a really useful exercise, I want to go to another project you've been busy on, and it's pretty exciting. You are now an author. You joined Charles Kindleberger and Robert Aliber for the Eighth Edition of the famous book Manias, Panics, and Crashes: A History of Financial Crises. You've come in as a coauthor on this Eighth Edition, so please tell us about this journey.

McCauley: Fair enough. I was a student of Charlie’s, taking his course on the history of finance in Europe when he was finishing up this book, and I remember reading chapters and giving him my response. As he looked to hand over the reins to somebody else, I was actually in Hong Kong. I have a letter from Charlie saying, "You'll understand [that] it'd be better if the new author were here in the United States." Bob Aliber is a very good writer and had many successful books under his belt, so he was a natural choice. Bob Aliber took the fifth, sixth, and seventh editions. Now, Bob has turned it over to me, and I'm proud as punch to be a third author. Just as background to your readers, the original book was published 4 years before the crisis that it predicted. Many economists would tell you, "You can't predict crises. You might suspect them, but you can't really be sure." Charlie was pretty darn sure already by 1977 that the lending to the Mexicos, Brazils, and Argentinas was not going to end well. That got him into looking into parallels in history, other foreign lending booms that went bad, and he called that one right. Again, I'm proud to be associated with such a classic.

Beckworth: You contributed to the book both by editing the chapters, but by also authoring in the book, and you have a chapter you've added to that, Chapter 13, is that right?

McCauley: Right, there's two chapters that are all new, Chapter 13, which is, “The 21st Century International Lender of Last Resort,” so I stopped the story with, more or less, Kindleberger's last pass, which came around the year 2000, and then try to tell the story of what happened in 2008 and 2020. There's another chapter that I just couldn't resist writing. It doesn't really fit with the outline of the book, which is all by topic rather than by particular manias, panics, and crashes. There's not a separate chapter for the tulipmania. There's not a separate chapter for the South Sea Bubble or whatever, but there is a separate Chapter 14 for Bitcoin because I just couldn't resist it. Not that it really deserves a place by virtue of its macro implications as we've seen at least so far, but because the thing was just so wild, so beyond the imagination of all the people who've written on this subject until just recently.

Beckworth: Yes, and that Chapter 13, circling back to that, that's a nice segue into your article because they touch on similar topics, the same topic, in fact, and I want to use that as a motivation to start our conversation now. We know from the movie It's a Wonderful Life all about bank runs, not being able to get your money out of a bank, what happens, people run to the bank, there's not enough reserves there to go around, so you have a bank panic. We also confirm that for the notion of a lender of last resort. In Chapter 13, you extend this idea, and again, in your paper, which is titled, *Bond Market Crisis and the International Lender of Last Resort.* You take it and you extend it to a bond market run. That may sound strange or new to some people, so maybe walk us through that.

The Basics of a Bond Market Run

McCauley: Okay. Let me step back a bit and say there are also money market runs. Maybe the money market run is a little easier to understand. Let's go back to 1970. At that point, the commercial paper market was already sizable, not as big relative to the banking system as it is today. In those days, it was big enough. One of the biggest issuers, and one that people thought of really sterling credit quality, a railroad called Penn Central, went unexpectedly bust. That led to wholesale withdrawal of investors from this market. Now, this market, it's not really a trading market. Paper is issued for a matter of weeks, or at maximum, months. It doesn't really have a secondary market, but it matures.

McCauley: Then it needs to be rolled over, so what happened was maturing paper couldn't be rolled over. This was a challenge to the Fed because it wasn't a run on the bank. It was a run on this commercial paper market. Investors just weren't rolling over to paper. What could the Fed do? Well, the Fed at that point used the banking system, essentially undid its usual moral guidance on the discount window and said, "Listen, come to us. We'll be happy to lend if you are lending to the companies that can't roll over their commercial paper." That's the way it worked, in fact, the Fed made quite a sizable set of discount window loans and the banks came to the rescue of the industrial companies and others that were financing themselves, payrolls, inventory in the commercial paper market. We got over that run on that market through an essentially bank-centric approach where the Fed worked through the banks. That gives you an idea of a run on a money market or a paper market, if you will.

Beckworth: Okay. That's a money market. How does that segue into a bond market? How would that work?

McCauley: Well, things are a little different with bonds. They do trade in a secondary market, and they have longer maturities to begin with. The risk is not a sudden disappearance of credit as with the commercial paper market, but rather that the secondary market freezes up. Essentially, people who own bonds and need cash cannot convert the bonds. They become effectively unsaleable accepted fire-sale prices, and as time goes on, the longer the market remains frozen, the greater the chance that companies, as their bonds mature and they need to roll them over, end up defaulting on them just because they can't come up with new money to pay off the old investors.

McCauley: It's a different dynamic with a run on the bond market, but it gets you to the same place where there is a macroeconomic threat. Just to remind you and your listeners, the corporate bond market is the modal place. That's the go-to place for corporations in the United States these days to finance themselves. Bank loans are much smaller than outstanding corporate bonds. In Penn Central days, by increasing bank loans of the big weekly reporting banks by, I think, 3%, the Fed was able to finance a 10% reduction of the commercial paper market. That was the relative proportions. Ultimately, the commercial paper market shrank by 1/3, so it was a big run, cumulatively, but the banking system was there as a shock absorber. Well, these days, the disproportion between the size of the corporate bond market and the scale of corporate lending by banks is such that you don't really have a serious possibility of a shock absorber there anymore.

Beckworth: That's a great point. Just to underscore that behind all of this, behind your articles, is this big change happening in the financial system. We're going from bank finance to market finance, from banks to markets, money markets, bond markets, and that's something that once you realize that and accept that's reality, it has big policy implications. We'll come back to those, but it's an important point, I think, to keep in the back of our minds as we go through this conversation. There's a huge transition taking place. Back in the 1970s, you could work through banks, less so today because of that change. Let's go back to the bond market run. You've described it. Do you have an example of an early bond market run?

McCauley: One that comes to mind was back in the days of Mike Milken. Milken, rightly, is credited as the inventor of the junk bond. Actually, junk bonds hadn't existed before Milken, but they existed as fallen angels, that is, companies that were originally investment-grade, perfectly credit-worthy bonds and then were downgraded, and those became junk bonds. In some ways, what Milken came up with was a process innovation where the junk bond was, at issue, a low-quality bond, rather than just becoming that by accident as it were. This was an invention, and he ran with it. There were abuses. It was really a mania for corporate leveraging at the time. It came to a head in late '89 with an attempted leveraged buyout of United Airlines. When you think about an airline, it's not an obvious candidate for a leveraged buyout. It's not like it has consistent cash flows that you can leverage up. All you need to do is have some downturn in travel, much less a pandemic, to prove to you that airlines are not a suitable object. In any case, it failed this leverage buyout, and then the whole junk bond market basically froze up.

McCauley: The only thing that unfroze was that the buyout fund, KKR, which is obviously still around, had enough money left over after doing its leveraged buyout of RJR Nabisco, that it still had money to put into the firm and allow it to improve its finances enough to roll over its debt, which otherwise threatened to be completely unfinanceable and drag down the whole company into bankruptcy. That one didn't require official intervention, but it benefited from a very lucky circumstance, that KKR happened to have leftover money in the same buyout funds that had originally done RJR Nabisco, but hadn't KKR not had the scratch at that point, you would have seen the junk bond market produce a whole cascade of defaults as bonds matured, relatively short maturities, and companies couldn't find financing elsewhere and just ended up clogging up the bankruptcy court. That's the way that one could've gone. It was very, very close. We dodged a bullet on that one.

Beckworth: It could have been a big macro event, but private firms stepped in. Now, the challenge moving forward is the markets are getting bigger and bigger, harder to find some private financial intermediary to step in or a firm to step in and take that place. In fact, let's go to 2008. We know what happened in the great financial crisis, or some called it the Great Recession. I don't recall seeing a corporate bond run then, but we did have some challenges with commercial paper, which is just a shorter version of it. Walk us through that.

The Commercial Paper Fiasco During the Great Recession

McCauley: Exactly. You know the story broadly. The oldest money market fund in the business, in fact, had, as it happened, some commercial paper of Lehman Brothers, and they had enough of it, so that the day after Lehman Brothers declared bankruptcy, this money market fund had to report to its shareholders that their shares were no longer worth $1, called breaking the buck in the Wall Street lingo. All hell broke loose after this money market fund broke the buck [and], basically, all institutional holders of funds that invested in bank liabilities and corporate liabilities rather than government liabilities were subject to a massive run. We started with a run on this, some call it a shadow bank. I don't think that's terribly appropriate.

McCauley: This quasi-bank, I would call it the money market fund. The money market funds are forced to take the money they have with companies, and especially banks, and especially foreign banks, and not roll that over. The run on the money market funds translates into a run on the commercial paper market and on the CD, the certificates of deposits of the eurodollars of non-US banks in particular. That's the run we had, the securities market run, the paper run we had in 2008, and that was very serious. Again, commercial paper market is where a lot of inventories get financed, payrolls get financed by major companies. Finance companies that finance everything from automobile loans to boat loans, to credit cards, all do their fundraising very heavily in the commercial paper market, so this was a serious problem the Fed faced in 2008.

Beckworth: Was this unprecedented? Was this the first time we see the Fed stepping into the corporate finance sector and making a big impact?

McCauley: Again, back in 1970, they had dealt with Penn Central, but they were able to do it at one remove, working through the banking.

Beckworth: That's right, yes.

McCauley: This time, no, that was not on, and the way they approached it was twofold, or threefold actually. The Treasury itself, the Exchange Stabilization Fund in particular, guaranteed the liabilities of money market funds. That was one thing. That's not quite the government lending to the money market funds, but it's pretty close to that. Probably more important was that the Fed bought outstanding asset-backed commercial paper. That's where the real problem was. Asset-backed commercial paper was financing all sorts of dogs and cats from the mortgage markets. No one wanted to buy that paper as it matured, or they didn't even want to hold it.

McCauley: So, the Federal Reserve Bank of Boston bought up paper at one remove by making non-recourse loans to banks that in turn bought the asset-backed commercial paper. Then the New York Fed had a program where they've basically underwrote commercial paper for a fee. GE Credit went to the New York Fed and said, "Yes, we want to sign up for this program to the extent of, let's say $100 billion. And as we try to roll over our commercial paper for GE Credit, if we can't find buyers, then in this special purpose vehicle created by the New York Fed, you buy our commercial paper." The Fed is the underwriter of last resort in that case. In the Boston Fed case, they're the buyer of last resort of really toxic commercial paper. The Fed stepped into that in a way completely different from 1970. They worked through the banks, ostensibly in the case of buying the asset-backed commercial paper, but a non-recourse loan to the bank so it can buy paper is pretty close from an economist standpoint at least to just buying the paper outright. The Fed wasn't buying it outright, but it was doing that at a very small one remove.

Beckworth: So the big difference, then, between the commercial paper incident in the 1970s and 2008 is just the fact that the markets have changed and more market financing. Therefore, the Fed had to intervene in a very different way than in the 1970s. 1970s, go through the banks. 2008, it had to do a number of creative ways and getting much more directly engaged and indirectly through underwriting in the commercial paper market.

McCauley: It didn't help, David, that the banks themselves were in bad shape in 2008. Back in 1970, you had a reasonably well-capitalized banking system able to be a shock absorber, but the banking system itself had loaded up on the crazy mortgage-backed securities, and so the banking system was in no shape to help the commercial paper market. The banks needed help at the same time. The Fed, both because of the relative size of the commercial paper problem relative to the banking system, but also because the banking system had gotten itself into a pretty bad fiddle, the Fed could not operate as it did in 1970.

Beckworth: That's a nice segue to the next event, 2020, because as you note, the banks weren't there in 2008 to act as a buffer because they were being run on. They were in trouble. After that crisis in 2008, Dodd-Frank, SEC, a bunch of new regulations come in that forced these banks to fund with more capital, a lot more regulations, liquidity requirements, which decreases their balance sheet capacity to intermediate in these growing markets. You see less, again, further downward involvement by the banking sector, which leads us to 2020. I know many of our listeners will know this crisis well because we've just went through it a few years ago, but walk us through the overview, what happened there, and how does it tie into this bigger story we're telling about the transition from bank finance to market finance?

Breaking Down the 2020 Crisis and its Implications

McCauley: Well, you put it well, David. The Dodd-Frank reforms made the banks trim their sales. The market-based financing had only gotten bigger. The corporate bond market had grown incredibly in the intervening years. That made things even more lopsided, made it even less possible for the Fed to work through the banking system if there were a problem in the markets. At the same time, the banks were in good shape come 2020. Instead of having a run on the banks, as we did have in 2008, we had a run into the banks, in fact, and this starts the so-called dash for cash. You can say it starts with companies that are suddenly considering the possibility of their revenues dropping to zero overnight, and they still have got costs.

McCauley: They don't know what costs, but they're looking at the possibility of really ugly negative cash flows. Dating back to 1970, in fact, banks have been selling companies commitments to lend and these formally backed commercial paper markets to some commercial paper outstanding. If you were Pfizer and you've got a commercial paper program of $20 billion or something, then you've probably got at least $10 billion of commitments to lend from banks. There you are, a corporate treasurer, at that point you don't know how your cash flows are going to look. What do you do? You call up your bank, and you say, "I want to draw down that $10 billion." The banks were not being run on in the sense of depositors worried about their money. Quite the contrary, in some ways, companies and individuals wanted more in the way of bank deposits, the most liquid thing they can hold. To get those bank deposits, the companies were hitting banks and asking them to pay up on these credit lines.

McCauley: There was a dash for cash by companies, and that put the banks under some pressure. The dash for cash also hit the money market funds. Again, the ones that invested in more risky bank and corporate securities, they were hit by demands for liquidation. Again, people are going from some near money, the shares in a money market mutual fund, to bank money and trying to make sure their liquid resources are really available and liquid. That was another piece of the demand for cash coming out of that sector. Then there were various demands also on the bond market that came at the same time.

Beckworth: So, not entirely the same as 2008, but there is some déjà vu here, there's a run on money markets, and this is where the story gets interesting in terms of your paper and your chapter in the book. There's a run on bond markets, both the Treasury and the corporate bonds. Walk us through that story and the lessons and insights that it shares.

McCauley: Fair enough. There's a kind of perfect storm in the bond market. Again, back in 2008, everybody wanted to hold Treasury bills, but this time holders of Treasury securities wanted to sell. Two very important classes of holders of Treasury securities wanted to sell. First, there were some hedge funds that were doing what are called relative value trades, a sort of fairly low-risk arbitrage under normal circumstances. Since it's low risk and low return, the only way to really make it pay is to leverage it up. You've got fairly leveraged positions where a hedge fund is holding a US Treasury security, which is cheap, financing it in the repo market, and then it shorts the Treasury bond futures, which is expensive.

McCauley: Eventually, the price of these two things converges in part because by construction, some of the Treasury bonds are actually deliverable into the futures contract. Eventually, these things converge, and there's money to be made off of that convergence, small amounts, but again leveraged 10 to 1, it adds up. Well, with the turmoil that began in the bond market, these trades suddenly started going very, very wrong. The Treasury bond has got still cheaper, and the Treasury futures have gotten even more expensive. Instead of converging, the thing was diverging. They were losing money, and they had to undo these trades very quickly. Now, the numbers are not all that easy to assemble.

McCauley: You've got hedge funds that are headquartered in Caribbean islands. They show up in the data one way and others that are headquartered in Connecticut, they show up another way. But, there seems to be a couple hundred billion of sales in pretty short order by such hedge funds. Another big holder of Treasuries is foreign central banks, and they remember 2008. What they remember about 2008 is they needed dollar cash. Why? Because they were intervening to support their own currencies against a strong selling of dollars, so they needed to stop holding Treasuries and start holding dollar bank accounts to settle those sort of trades.

McCauley: They also remembered in 2008 many cases that they came to the support of their own banks or their own companies. So, foreign central banks that are holding, normally, Treasury securities of two to five-year maturity because those have better returns than Treasury bills, they're suddenly selling in huge volumes. The so-called safe assets suddenly become unsafe assets as their prices start to really gyrate. Worse yet, from the standpoint of a holder of Treasuries, the market gets harder and harder to sell into. The hedge funds are holding so-called off-the-run Treasuries, relatively illiquid Treasuries, where this game has particular juice in it, and those kind of securities are harder and harder to sell. You've got these holders of Treasury bonds that think of them as these nice liquid assets that can be sold in huge volume instantaneously, and then suddenly, they can't be sold in huge volume instantaneously, but they still need the cash. So, the market is getting all of these sell orders from both of these sources. That brings in a kind of reaction, a third group, which is mostly households that hold bond funds. These can be Treasury bond funds, or they can be all bond funds, or they can be corporate bond funds.

McCauley: But what had happened in the intervening years with low interest rates was a lot of households looked and said, "Do I want to get a zero interest rate from the bank or my money market fund, or do I want to get 2.5% or something from a bond fund?" Besides, the interest rates weren't moving around all that much so you could look at your monthly statement and not have a heart attack or you could even stop looking at your monthly statements, you began to think of this as near cash. Suddenly, of course, the prices of these bonds are gyrating around. If you're mistaken enough to look to see what the value of your bond fund is, you're likely to see that it's not doing so well at all, or it's a lot different today than yesterday. Suddenly, it's not at all what you thought it was, and you want to sell. Now, there's an argument between those who say the households started acting completely differently, treating this thing as a risky holding all of a sudden or the people with the Investment Company Institute who say, "Well, according to our estimates, when the bond market goes down, people predictably sell these bond funds. We got no more selling of these bond funds than you would predict given what had happened to the price of the Treasury bonds and corporate bonds."

McCauley: So, we'll put that argument aside. One way or the other, there was, again, hundreds of billions of dollars of selling coming out of the household sector, and this is all hitting the market simultaneously. Meanwhile, the primary dealers, the dealers in Treasury securities, they're lucky if they’ve got half the people working, and they're not even in the office. And so, literally, on the supply side, you have a shrinkage of the capacity to do trades, not to mention that anybody doing risk management at one of these firms is saying, "No, no, no,” at this point. The banks that own the dealers are meanwhile being hit by all of these demands by companies on their commitments to lend. You can see this is a bad moment for the bond market with a lot of demand for liquidity and quite a limited supply, and prices are going up and down like penny stocks rather than the core asset of the whole international financial system.

Beckworth: Quite the perfect storm right there. People weren't in the office, multiple parties withdrawing, demanding funds, so everything is coming together at one moment. This is the famous dash for cash in March, 2020. The Fed steps in, obviously, it responds, and it creates an alphabet soup of liquidity facilities. I don't know if you want to walk through those, give me your thoughts on them, maybe just a bird's eye summary. What do you think of its response?

The Fed’s Response to the 2020 Dash for Cash

McCauley: Well, an important response is that the Fed uses its emergency power to lend directly to the primary dealers, lend directly to the biggest bond dealers. That's important because though Glass-Steagall seems to be completely gone, it's still there like the Cheshire Cat's grin in the form of prohibitions that keep the bank holding company from funding the broker-dealer. The fact that the bank is liquid and has plenty of cash and access to the Fed doesn't mean that the broker-dealer has plenty of cash. The Fed basically put itself into a position to be a lender of last resort to a nonbank that, by and large to be sure, is embedded in a larger bank holding company structure, but nevertheless, one that is legally separate and still bound by these Depression era rules. That's very important. Just doing that shows some good effects. Mostly, the Fed just steps in and starts buying Treasuries. The orders to Lorie Logan and colleagues at the operating desk in New York, there's no number mentioned. It's what is necessary to stabilize this market.

McCauley: In a matter of two, three weeks, the New York Fed buys bonds larger than all of the sales I described before, larger than the hedge funds were selling, larger than the foreign central banks were selling, larger than the bond funds were selling, so fully offsetting all of the sales, the Fed's balance sheet takes on all of these bonds. Then, in two steps, the Fed steps in to buy corporate bonds as well because buying Treasuries and buying agency securities still leaves the spread between corporate bonds and Treasuries to the market. Again, it's a pretty blown-up market at that point, a pretty cratered market with participants running around in no man's land, so the Fed announces that it will buy corporate bonds.

McCauley: Now, we've gone through at some length how the Fed bought commercial paper in 2008. This is a big step, but it's not a completely new thing. It's buying private paper that the Fed is generally not authorized by the Congress to buy and to hold, but using its emergency power, stepping in to buy corporate bonds. But, it is unprecedented and it's going out on the yield curve. It's going to longer maturity paper, and there's nothing in the way of precedent, but some people were calling for it, so it wasn't like it was a complete surprise. I wouldn't say that. But, it was certainly unprecedented that the Fed would do that. Then I think, probably more surprising, a couple of weeks later, the Fed actually announced it would buy junk bonds as well. That was more surprising.

Beckworth: Just to summarize, so the big change at this point is that now the Fed is getting engaged with corporate finance, but with bonds, not just commercial paper, which it had done before. You mentioned these two corporate bond facilities. There was the investment grade and the junk bond ones that came, but also the primary dealers. The Fed was working through primary dealers buying bonds as collateral from them, corporate bonds. This was definitely something new. You heard reverberations and people saying, "Have we crossed a Rubicon? Is the Fed going to be the financier of everything?" We'll come back to this concern a little bit later. We'll talk about some of the issues of flow from this-

McCauley: But the action on the Treasury market was pretty remarkable as well because whereas Bernanke and company had said, "We're going to buy so many bonds over such and such a period," so it was a programmatic thing and the justification had not to do with the fact that the market had fallen apart, but rather that they wanted to put pressure on long-term yields, the so-called term premium, make it cheaper for companies to finance with bonds and all that stuff, so there was a monetary policy sort of story that was told about the QE, but what was going on there in March of 2020 was not QE. It wasn't like we're buying so much this week or something, they were just buying whatever was necessary. That was quite different, in terms of the intervention in the bond market that the Fed was doing. I can't think of a precedent for that either.

Beckworth: Yes, so the scale was remarkable. Let me just summarize a few things here. The Fed did the repurchase operations, over $1.5 trillion. It did the currency swap lines, and it extended it to a number of countries, and we'll come back to this in a minute as well. It really opened up swap lines to many, many countries around the world, not everyone, but many. It did the commercial paper funding facilities you mentioned, primary dealer credit facilities we talked about, money market fund liquidity facility, the two corporate bond facilities, and then the new foreign and international monetary repo facility, a repo facility for foreign financial monetary and ministry of finance authorities.

Beckworth: It did all of that and extended the list of counterparties. It seemed really impressive and it was. It was unprecedented as you said. However, was it enough? The number of countries, its counterparties, was it adequate, do you think, to do the job? Spreads did come down, so the answer seems to be yes. I asked that because it was very extensive in the number of countries doing currency swaps, but as you note in your paper, it bought just domestic or domestic-related corporate bonds. Is that appropriate? Is that adequate? What are your thoughts on evaluating that?

Were the Fed’s Policy Actions Enough?

McCauley: You're asking, simultaneously, did they do too much? Did they do enough? Well, let's take the do enough, and on the swap front, they had the central banks that they went to basis of lending on an unlimited basis, again, the same ones as in 2008. Then they, as you say, extended the list to another half dozen or so central banks. Did that work? Yes, it worked. If you measure it by the gap between the three-month rate that was embodied in corporate loan contracts, was embodied in adjustable rate mortgages, it was still three months LIBOR at that stage. LIBOR had started widening in March away from the Fed-set overnight rates and their expected values over the period of a month or three.

McCauley: The Fed was right on top of that. What it took them a year to do with the swaps in 2008 in terms of the frequency of operation, in terms of number of counterparties, in terms of the maturities, the operations, they went all through that playbook in a matter of days, what had taken a year. LIBOR had started to gap off of the Fed rates, and it was brought down in very, very short order. It was nothing like in 2008. The Fed was right on top of that, and it was amazingly successful. If you ask, well, why didn't they open up the swap lines to more central banks? If you look at the way that the foreign exchange markets trade, the core central banks they chose, the major central banks, account for two-thirds of the forward trading in all currencies according to the BIS Triennial Survey. Just with five central banks, they already were including most of the trading in the foreign exchange market. By adding the other central banks on a temporary basis, they got up to, fully, five-sixths of the trading in the foreign exchange market. The foreign exchange market is not a general assembly of the United Nations. It's very much a Security Council sort of operation.

McCauley: The Fed's intervention in terms of its choice of counterparties matched what wasn't random and matched the hierarchical nature of that market to such an extent that they were able to include most of the overwhelming majority of trading with what seems to some to be a relatively choosy, short list of central banks. That's just the way the world works. Plus, there's no saying that somehow the money didn't get in the cracks, even when they were not lending to a central bank. The example I cite is the Swedish Krona where if you look at the chart, the cost of dollars, I should say, in the Swedish Krona/dollar market rose in tandem with the cost of dollars in the eurodollar market.

McCauley: You can see in the Swedish Krona market how even before the Fed arranged a swap with the Riksbank, the Swedish Central Bank, that its operations with the ECB sufficed to bring down the cost of dollars as faced by traders in the Swedish Krona/US Dollar market, so the cost of dollars went up against the Swedish Krona as against the euro. When they started doing big operations with the ECB, again, before they even announced anything with the Swedish Central Bank, the cost of dollars against Swedish Kronas went down. The diffusion of the good effects of the Fed swaps with the ECB extended well beyond the euro to this other currency in Europe. It helped, of course, that the banks were in good shape unlike 2008. If you are a French Bank, you could be looking out to where you're going to make the most money using the dollars that you're getting from the ECB, and if the answer is by doing a swap with a life insurance company in Sweden, you're going to do that rather than using it in the euro market. Again, how the Fed intervened, the precise market in which it intervened, the precise counterparty it chose, turns out not to be necessarily determining of the effect of the Fed's lending out the dollars.

Beckworth: Do you think also that the FIMA Repo Facility also closed any holes or filled any cracks that may have otherwise been missed? You just argued, I think fairly, that most of the needs were met. Everything was taken care of. Spreads came down. The evidence is pretty clear. Does the FIMA add an extra layer of protection? What are your thoughts on that facility? Because it's new, too.

McCauley: Yes. There's three circles the Fed has drawn. One is the major central banks with the unlimited amounts. Then there are the temporary arrangements with another group of central banks. Then there's any central bank in the world that holds Treasury securities with the New York Fed can go in on a pawnshop style and get dollars against it. The Fed brought that in because it was observing that the central banks were selling their Treasury securities, their three-year, five-year securities, and then just leaving the money overnight with the New York Fed. It's like, "Well, we can keep them from selling the Treasury security in the first instance if we just allow them to encash their holdings of Treasury securities temporarily for dollars with us." That was the inception of the FIMA. It hasn't been used all that much, but I think it is an important third circle. Of course, not all central banks hold all of their dollars at the New York Fed. Some hold them offshore. Some don't hold Treasury securities as much, so the coverage is far from universal, but it is a further step, an important outer circle.

Beckworth: Okay, so I want to get back to corporate bonds because this is the thrust of your article, but one last question since I have you and I don't always get to talk to you, Bob, and that is, the Standing Repo Facility, which was introduced recently as well, do you think that would've made a difference in March, 2020, or does it need to expand, maybe, its list of counterparties? I know Jeremy Stein was at Jackson Hole and argued in a comment in response to a paper by Darrell Duffie touching on some of these same issues that one solution would be just to take the Standing Repo Facility and extend its counterparties to some of those people who were selling Treasuries in March, 2020. I'm curious to hear your thoughts. Is that a potential fix for something like a March, 2020 in the future?

McCauley: I think it would've changed things a bit, but I think, probably, the FIMA, dealing with the central bank sales with this device, was probably the right place to start. The hedge funds really needed to get out of their positions. They didn't need to just get cash against their Treasuries. They needed to stop holding the Treasuries. When you looked at your bond fund and saw that the price had gone down 3% in the last two days and wanted to sell, you weren't looking to borrow against your bond fund. You were looking to get rid of that exposure. You didn't want to see any news like that in the future. I think it depends on where the run is coming from, and I would say [that] in two out of the three cases back in 2020, it wouldn't have done all that good.

Beckworth: Because it's a repo facility, which is just lending overnight. It's not unloading the Treasuries altogether. Fair enough.

McCauley: Right. The Fed is not taking the price risk from [inaudible] repos with you.

Beckworth: Well, let's go back to corporate bonds. This is one of the key insights that your article delivers. Walk us through how the corporate bond facilities worked, and some of your concerns about that approach.

Breaking Down the Corporate Bond Facilities and Possible Concerns

McCauley: Well, it worked very well. There are things that already had begun to improve just with the announcement of the primary dealer lending facility, but shortly thereafter was the announcement on the corporate bond front. That turned things around remarkably, they didn't have to buy just on the basis of the announcement, both prices and quantities turned around. The price of corporate bonds started to go up just after the announcement, that happened with investment grade corporate bonds immediately, even junk bonds and international bonds, global bonds, things like dollar bonds issued by Brazil or Sweden or something, those all started lifting off as well. The price reaction was very quick, and interestingly extended beyond the corporate bonds they had promised to buy to corporate bonds they had not promised to buy, and to other non-US corporate dollar bonds that are all close substitutes in investor portfolios.

McCauley: The effect was immediate, in days, and also, the sales of bond funds by households and so on, that stopped getting worse and worse. That was an important sign too that the force of the selling in terms of quantities was also relieved almost immediately. Then when they announced that they would buy junk bonds, of course, the junk bonds jumps more, the investment grade jumps more because they said they'd be doing more. Also, the non-US corporate dollar bonds jumped, and the flows continued to improve. Both announcements worked. It worked so well, in fact, and it took them so long to actually get their ducks in order to buy the bonds, that there were serious suggestions including from the senator from Pennsylvania, that they'd just not do it. Chairman Powell was quizzed in the Senate, "Do you really have to do this?" His answer was, "Well, we said we'd do it, we have to do it," but the truth of the matter is, it was like the truck labeled Federal Reserve or something pulled up at the bank and all the people waiting in line looked at it and said, "Ah, okay, time to go to the deli." That was the end of it, or at least the beginning of the end, and the effect was largely the announcement, and the actual buying when it finally happened was an afterthought or anti-climax, I should say.

McCauley: So, it worked. Now, there were those of us in real-time who had quibbles about this. David, I have to tell you, especially once they had announced they were going to buy junk, I racked my brain and said, "How should they buy junk?" Clearly, how were they going to buy investment-grade bonds? They were mostly going to buy them through exchange-traded funds, ETFs. Now, ETFs are kind of a bad idea for bonds in general, not such a great idea for investment-grade bonds, but a really dreadful idea for junk bonds, because you're basically saying, "I'll take any garbage that somebody manages the pedal in this market, and add it to my portfolio." To take the market when the market includes the drag seems to me to be not responsible investing. In fact, the Fed had been warning the banks over the previous five years that when these private equity funds were bringing their portfolio companies to market, or when they were extracting dividends from them in a rather untimely fashion, and the companies were going to the banks and the bond markets with cash flows… with debts six or eight times their cash flows, the Fed was saying, "No, you banks should not be joining these deals."

McCauley: The deals went on without the banks, frankly, because the private equity, and the bond funds, and the leveraged loan funds, the whole parallel credit system could mostly do without the banks. The Fed had been, to my eyes, quite reasonably telling banks not to get involved in really junky corporate finance. Then all of a sudden the Fed is wading into the market and buying, guess what? Probably not the worst of it, since the worst of it ended up in the loan market, but there was still some of this paper in the junk bond market itself issued by companies that the Fed had told the banks to leave alone. It was the old Groucho Marx line about not wanting to be a member of a club that would let him in, so somehow the Fed was not a paragon of consistency at the point when it's buying the stuff that it told the banks not to help underwrite in the first instance. There's even a story, I need to chase this one down, about how this company that owns Bitcoin sold a bond. That went into the exchange-traded fund. The Fed has since sold them, of course, but I think there's a serious chance that therefore, the Fed actually owned a bond issued by a company whose claim to fame was that it was holding Bitcoin. That just illustrates how awkward it can be when you're just buying anything that comes down the pike in the junk bond market.

McCauley: My thought at the time was that the Fed needed to actually buy bonds on the desk itself, that it couldn't use the device of the ETF, or if it was going to buy a fund, buy one like the one Vanguard does that specializes in double B, the cream of the junk as it were, rather than taking something that just, as a matter of principle, buys anything that's once moved. Now, in his book, Nick Timiraos, Trillion Dollar Triage, quotes Chairman Powell saying, "Well, we've got some criticism for buying a junk bond, but if that's the worst they got on us, then that's not too bad considering how fast and furious things were going." I suppose that's a defense of a kind, but it was quite a while between even when they announced they were going to buy junk and when they did.

McCauley: I guess the broader point I would take away from that is that the Fed really should be in a position to buy individual bonds. It should know this market, it is the biggest market for US companies, and I think Congress should actually give the Fed the power to buy and hold corporate bonds under normal circumstances. There are some in the system who believe we should hurry back to a Treasury-only policy as if that gets you away from credit risk, but I think from a deeper perspective, you can say, "Well, there is credit risk in the Treasury too, and having the Fed only buy the Treasury is not being neutral in the credit dimension, but actually favoring the government over everybody else in the system." I'd be in favor of kind of getting the Fed's actions here more regularized. That would put the Fed, I think, in a position if it had to buy junk in the future, to not buy the junkiest junk, and actually have a trading desk that knew how to buy corporate bonds the way it knows how to buy Treasuries.

Beckworth: Bob, the interesting point that you made in your paper about the corporate bond purchases, at least for me, was that it worked, but it was focused on domestic companies, or at least companies based in the US, their workforce in the US. There were some foreign-owned businesses, but they had to be US-based. Your concern, if I understand correctly, is okay, that worked, maybe we got lucky. As you noted, it affected more than just US corporations. It affected spreads across the world for corporations. Your concern, though, is it may not work next time, and this is important. Again, going back to our earlier kind of big meta point that financing has changed from bank finance to market finance. You note in your article, there's a large number of dollar-denominated bonds outside the US. I think you said 12.5 trillion. If the Fed is going to try to keep the corporate bond market safe or stable, at least in the panics, it needs to be aware that a run on dollar bonds could be overseas as well as in the US. That is your concern, right?

McCauley: Yes. I guess I'm worried that things worked out swimmingly this time, that the Fed put its thumb on the scale of US corporate bonds, and that moved the whole world's dollar bonds. The analogy on the banking side is that the Fed, in 2008, was busy lending through the discount window, including to foreign banks in New York, very heavily to foreign banks in New York. That proved not to be enough. They needed to lend through the foreign central bank, through the swap lines to the non-US banks outside the United States in order to get the LIBOR down, and in order to maintain some semblance of monetary stability. I'm worried that the scale of the non-US chunk of the dollar bond market, which is something like half the size of the US corporate bond market, that that's so big that the dynamics there could be such that intervention just in the US corporate bond market might not prove sufficient to stabilize the whole market. At that stage the Fed would have choice of going out and buying the dollar bonds of the French oil company, Total, or the Brazilian oil company, Petrobras, or the Kingdom of Sweden or whatever.

McCauley: Or another approach it seems to me would be to, on the analogy of the use of those swaps to lend to banks, would be to open up the swap lines to the foreign central bank partners and have them buy dollar bonds sort of on a concerted basis. You buy your bonds, we'll buy our bonds, and we'll provide you with the dollar so that the ECB or the Bank of England or Swiss National Bank or Bank of Japan would be taking the risk of buying the dollar bonds of its nationals or residents, but the dollars would, if necessary, come from the Fed. That's my imagination of disaster at work, I suppose, and my notion of how to finesse the problem of the dollar bond being cosmopolitan. And so far, the intervention of the Fed is purely national. So how do we get a bond market intervention that's as cosmopolitan as the dollar bond market? Now, no one at the Fed asks all these non-US companies to sell dollar bonds in the first place. It's not like we're responsible for them in some sense, but i'm imagining a world in which the fact that there's only buying in the US segment of the market isn't enough to stabilize the thing, and then it becomes in the US interest that there be a broader attempt to stabilize it, and it might need to be organized on a basis like I just suggested.

Beckworth: So, to summarize, we live in a world where the global dollar market is huge. It's growing, it's far outside US borders. When the Fed has to stabilize dollar markets, it has to intervene internationally, and we see it in money markets. Those currency swap lines serve the purpose of stabilizing money markets, short term. Your point is, look, corporate bond markets, dollar-denominated, are also huge. They're out there. They're increasingly an important source of financing for corporations. Again, it's part of this bigger shift from bank finance to market finance. Just as the Fed has had to face reality on the money market front, it needs to do so also on the corporate bond front.  And so, this is the challenge ahead of it. Your policy suggestion is to use the same approach that they're doing through the currency swap lines, to also use that facility to encourage foreign central banks and their banks to step into corporate bond markets and buy up dollar-denominated bonds. Is that right? If necessary.

McCauley: The same division of labor could be the approach where the Fed takes the risk of lending to the ECB, presume negligible, and the ECB takes the risk of buying the corporate bonds, dollar bonds of European corporations. The ECB, by the way, has experience in buying corporate bonds, only euro-denominated ones. In some sense, I'm describing a filling-in of the matrix, if you will, of currencies, and nationality, and recognizing that there's a big dollar bond market out there, and only part of it is the US.

Beckworth: This makes a lot of sense to me. It seems prudent, it seems wise, it seems to face the reality of the world we live in. Let me bring up, in closing, two concerns, one from the right, politically right, one more from the progressive or left. The right side would say, "Okay, we understand, Bob, you're a central banker, that blood runs through your veins. You want to stabilize the global financial system." Us more conservative folks, we're worried about the Federal Reserve getting bigger and bigger, its footprint growing more and more. Doesn't this mean a huge balance sheet and all of the other associated problems with that? Then the progressives might say, on the other side, “Bob, all you're doing is pushing this market finance even farther out there. You're moving financial activity from banks, which are regulated, they're in the regulatory perimeter, and now you're moving them outside that perimeter. You're further exacerbating shadow banking.” So, the right's worried about the Fed getting too big. I think the left's worried about regulatory arbitrage happening through shadow banking. How would we respond to those concerns?

Responding to Further Concerns Regarding Fed Intervention

McCauley: Those are both valid concerns. On the one side, I would avoid any prefiguring of this kind of intervention, so where the Fed is not a supervisor, where it's not getting regular reports of condition, it needs to remain cagey. It cannot give the BlackRocks of the world some obvious game plan to work against, that would be a big mistake. Even in terms of buying Treasuries, I think the Fed cannot make it clear under what circumstances it would be stepping in and buying Treasuries. I think the suggestion by Darrell Duffie and co-author at the New York Fed, that we should think about the US Treasury as possibly the stabilizing force in the Treasury market, I think that has a lot to recommend, the idea that the debt manager can buy back its own bonds if the bonds are suddenly being offered below par because of some market rupture, the Treasury can sell T bills and buy back the bonds. It's not clear to me that this is the Fed's job, or always the Fed's job, if the Treasury is not inhibited by a debt ceiling, it's got a big balance sheet to operate with the flexibility to issue short-term paper that should always have a pretty decent market.

McCauley: I think the suggestion by Hauser at the bank of England, and Logan now in Dallas, is well taken to the extent you do step into the market, you should confine it to the market's period of being broken down. You should not just sort of wade in, and then just keep going because no one told you to stop. You should evaluate when the market no longer needs the help and step away. That I think will help limit this, and maybe, make some of those concerns a little less. Well, let me go back, the beginning of the Federal Reserve, the design, the original design was the instrument of choice would be banker's acceptances. Now, banker's acceptances is sort of like a commercial paper only with a bank's signature on it.

McCauley: It's been a big loser as an instrument, but the founding fathers did not have the idea that everything should be in banks, and nothing should be in the markets. They designed the Fed to buy and hold and trade. The Fed did a lot to encourage the development of this paper market, in fact, and it lasted pretty long. I think the founding vision allows for the Fed to be comfortable with securities. It's just that all of that needs to be sort of updated to the security market that we have where the corporate bond is the most important way of financing private enterprise in the country. We need to make it so the Fed doesn't have to invoke emergency powers to operate in the market that's most important for jobs and production in the country.

McCauley: I would definitely move the goalpost for the Fed, and in a certain sense, make it seem less shadowy when it's operating in these markets. As for money market funds, I think we've had demonstrated repeatedly that this is a very unstable construct, that they're essentially banks without capital, and the Fed didn't object to them when the Securities Exchange Commission invented them in the 1970s. They've got a very powerful lobbying force behind them as we've seen. We've seen that the reforms didn't work, and I'm very unhappy with the idea that we privileged the government money market funds as if nothing could ever happen that would make people worried about the government paper.

McCauley: Imagine a debt limit problem causing runs on government money market funds, or some problem in the Federal Home Loan Bank System causing runs. We would be back playing the same game again. So, I think as it happened, Paul Volcker was distracted by 17% inflation at the point these money market funds came along. He had other fish to fry in terms of his political priorities, which we cannot really blame him for, God rest his soul. But I think now that we've had them tested twice and found wanting twice, it's time to do something about these banks without capital in our midst. Otherwise, we're just going to have trouble with them again. I yield to no one in my willingness to confront shadow banking in a straightforward fashion, David.

Beckworth: Okay, Bob. This has been a fascinating conversation, and I have one final and related question, and that is, where does this all end up? Is there a limit to the size of the global dollar system, and therefore the need for the Fed as a buyer of last resort? One could imagine, for example, that the better the Fed does in stabilizing global dollar markets, the more that this global dollar market will grow. Is there a natural limit, or what do you see happening here?

Is There a Limit to the Global Dollar System?

McCauley: David, you're right. There is a sort of Triffin-style problem here where the global dollar market grows with the whole world's growth, which is faster than the US. If you think of the Fed's ability to ride to the rescue as being ultimately grounded, which it certainly is, but somehow limited by the size of the US economy, then there is, over time, a sort of an increasing disparity between the need and the capacity that might worry folks. I would recall, too, that when the Fed did 600 billion of swaps with foreign central banks back in 2008, 2009, that was about 5% of the dollar liabilities of the non-US banks. It didn't take the Fed coming in for 10%, or 15%, or 30% of those liabilities to stabilize the situation. Again, with the bond markets, we're talking tens of trillions.

McCauley: It might worry you, but again, recall that the Fed did, yes, trillions of Treasuries, but essentially zero in the corporates in 2020 to stabilize things as it wanted to. Plus, we've seen that the Fed's balance sheet is more expandable than anybody might have imagined. That's why I think it's important that we get that balance sheet down during peace time so that it is available in wartime, as it were. Let me close by suggesting that the limits here are more political than balance sheets, more politics than economics, that it's the Fed's necessity to convince the American people and its elected representatives that what it's doing is in their interest and doesn't represent some effort on behalf of Davos Man out there or his minions.

McCauley: That seems to me to be the problem, particularly in a fragmented world. We've got a world out there where something other than friends of the US have banking systems that have lots and lots of dollar liabilities and assets, and while some of these countries are self-insured, you might say, with tremendous dollar reserves, it's still far from impossible to conjure up a situation where the US might well come to the rescue of a banking system that is owned by folks that people in the Congress do not approve of. It seems to me… in the old days, back in the '60s, the people gathering in Basel once a month and exchanging information on euro/dollar deposits and so on, those were all nearly allies. I guess, formally, the Swiss and the Swedes weren't allies, but generally, it was an alliance, or at least very much like-minded central bankers getting together to swap data and stories. That's not the world we live in today, so I worry about whether central banks and the Fed in particular can keep doing the right thing for global economic stability in a world that is politically fractured.

Beckworth: Well, on that note, our time is up. Our guest today has been Bob McCauley. Bob's new paper is titled, *Bond Market Crisis and the International Lender of Last Resort.* We'll provide a link to that, and also check out his new book, Manias, Panics, and Crashes: A History of Financial Crisis, 8th Edition. Bob, thank you for coming on the program.

McCauley: Thanks, David, for having me.

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