The Federal Reserve has responded aggressively to market strains and the sharp drop in the economy caused by the coronavirus pandemic. The central bank cut short-term interest rates nearly to zero, bought hundreds of billions of dollars of Treasuries and mortgage-backed securities and it introduced a plethora of special liquidity facilities designed to support markets. The Fed’s actions have largely worked, easing financial conditions and enabling corporations and municipalities to borrow in the U.S. debt markets. If I were in the Fed's shoes, I would have pushed for the same forceful interventions.
That said, the Fed’s actions have a cost because they tend to encourage risky behavior that we want to avoid -- a problem known as moral hazard. Not all of those who got help were blameless.
Consider, for example, the Fed's enormous purchases of Treasuries as trading began to seize up. It was, in fact, a backdoor bailout of highly leveraged hedge funds that were caught in an untenable trade of being long cash Treasuries and short Treasury futures. When volatility was low, these positions could be leveraged up to generate attractive returns. But when the pandemic hit and volatility soared and those trades lost value, margin lenders who financed the positions asked for more equity. This led to fire sales, with many sellers and few buyers. The result was a climb in Treasury yields, a widening in bid-offer spreads and a sharp drop in liquidity in what is normally the most liquid market in the world.
The Fed decided that the risk of a dysfunctional Treasury market was bigger than the downside of bailing out the leveraged hedge funds. Although the Fed helped stabilize the Treasury market, it also made it possible for the hedge funds to avoid bearing the full costs of their risky decisions.
The story isn't much different in the mortgage-debt market. As volatility soared, real-estate investment trusts that invest in mortgage-backed securities were forced sellers as they struggled to meet margin calls. Again, the Fed purchases helped limit their losses.
Heavily indebted corporation also got a helping hand. This is significant because many corporations took on lots of debt by choice. The Fed's response was to set up corporate bond facilities, limiting the fall in lower-rated corporate debt prices and keeping these markets accessible for companies that needed to raise funds. These actions also protected investors in high-yield mutual-bond funds. Had the funds been forced to sell amid plunging prices to meet large redemptions, this could have set off a chain reaction in which falling prices begat more sales. Both the asset managers and the retail investors who bought shares in these junk-bond funds escaped bearing the cost of their actions.
So why should we care that some not-so-innocent parties were bailed out by the Fed? Because it brings us back to moral-hazard problem: investors win during good times (they can assume more risk and earn higher returns) while the Fed and the U.S. Treasury (ultimately taxpayers) assume part of the downside risks when there is trouble in financial markets. This is likely to encourage even greater risk-taking down the road, making it more likely that investors and markets will need to be rescued in the future.
This doesn’t seem to be a good road to stay on. But getting off it is very difficult. After all, no one wants to risk a depression in order to teach hedge funds, mortgage REITs or mutual-fund investors a lesson. In fact, the key reason the Fed was established in 1913 was to ensure that the U.S. had a lender of last resort to provide liquidity when no one else would or was capable. The Fed's very reason for being was to help limit bank runs, and avoid asset fire sales and financial crises.
So what can be done about moral hazard?
First, structural weaknesses in financial markets need to be fixed in peacetime, not in the middle of a crisis. One obvious example would be to prohibit mutual funds from offering liquidity on-demand when the assets they hold are illiquid. The costs of this change would be very low. If you are investing in risky assets, you shouldn’t need to have overnight liquidity.