The Fed Is Killing the Two Main Functions of Wall Street: Price Discovery and Prudent Capital Allocation

Jerome Powell & Wall Street Cartoon

By Pam Martens and Russ Martens: April 11, 2020 ~

On Thursday, knowing that a three-day Easter weekend was coming and the attention of the public would be elsewhere, the Federal Reserve announced that it would allow two of its emergency lending programs to begin buying junk bonds. Those are bonds with less than an investment-grade credit rating, meaning they have a greater likelihood of defaulting. The Fed is not simply accepting junk bonds as collateral for loans, it will actually be buying junk bonds — potentially hundreds of billions of dollars of them.

Two of the popular junk bond ETFs, iShares iBoxx High Yield Corporate Bond ETF (symbol HYG) and SPDR Bloomberg Barclays High Yield Bond ETF (symbol JNK) closed the trading day on Thursday up 6.55 and 6.71 percent, respectively, on the announcement. Those ETFs had been plunging in price for most of the month of March.

For years now, prudent investors have been forgoing risky investments like junk bond ETFs and accepting a much tinier yield on U.S. Treasury securities. Now, high rollers like hedge funds that bought junk bonds and junk bond ETFs and received the higher yields, are getting bailed out of these risky bets. The markets will now, going forward, price junk bonds on a closer plane with Treasury securities, assuming the Fed will not let them fail.

This is effectively killing the pricing mechanism of Wall Street. A U.S. Treasury note has the unconditional guarantee of the U.S. government to make the timely payment of interest every six months and pay the principal at maturity. Junk bonds are backed by nothing more than deeply-indebted corporations, which can, and do, frequently file for bankruptcy protection, making their bonds sometimes sell for pennies on the dollar. But going forward, junk bond ETFs will be priced on the premise that the Fed may ride to the rescue.

This, in turn, results in more misallocation of capital across Wall Street, which was already being corruptly dispersed by Wall Street due to lapdog regulators at the Securities and Exchange Commission. It will now be dispersed not on the innovativeness or importance to society of what the corporation produces, but on whether the corporation has powerful friends in high political circles that can get it a bailout.

The two Fed programs that will be allowed to buy junk bonds along with investment grade bonds are called the Primary Market Corporate Credit Facility (PMCCF) and the Secondary Market Corporate Credit Facility (SMCCF). The Fed could have done this all under one program name but it learned from its nationalization of bad Wall Street bets in 2008 that if you have a mind-numbing list of alphabet soup emergency programs, it takes the public a lot longer to figure out what’s really going on: that is, that the Fed is allowing Wall Street’s fat cats to privatize profits and socialize losses. This can also be expressed as an institutionalized wealth transfer scheme to the 1 percent. (See Bernie Sanders Hasn’t Quite Captured What Wall Street Does: It’s Actually a Fraud-Monetization System with a Money-Printing Unit Called the New York Fed.)

Both the PMCCF and SMCCF, and almost all of the other emergency programs,  have been farmed out by the Federal Reserve to the New York Fed, a private institution owned by multinational banks who will be the main beneficiaries of having bad bets they made removed from their balance sheets and moved into a Special Purpose Vehicle (SPV) that the New York Fed is creating for most of these emergency programs. The losses in the SPVs will be borne by the U.S. taxpayer – up to a total of $454 billion thus far. That’s the amount that the current stimulus bill (CARES Act) allocated to these SPVs. If the losses go higher, it is assumed by the Fed that Congress will pass another stimulus bill, call it CARES II, and give more aid and comfort to the Wall Street fat cats while Fed Chair Jerome Powell makes his TV rounds telling viewers this is all being done to help American households and working folks.

The New York Fed has already signed contracts with the Wall Street asset manager, BlackRock, to manage the Primary Market Corporate Credit Facility (PMCCF) and the Secondary Market Corporate Credit Facility (SMCCF). The contract says that BlackRock will be allowed to buy up its own ETFs as well as those marketed by others.

It just so happens that the iShares iBoxx High Yield Corporate Bond ETF mentioned above, that got a price improvement of 6.55 percent on the news of Fed buying junk bonds on Thursday, is owned by BlackRock. No possible conflict of interest there, of course. It’s all going to help mom and pop on Main Street.

As for the critical importance of Wall Street providing prudent capital allocation, think of what happened to America during a prior era of crazy misallocation of capital by Wall Street. During the mania, unscrupulous Wall Street analysts working for the big investment banks were urging the public to buy shares of new businesses (hot IPOs) while the same analysts were calling the businesses “dogs” and “crap” in internal emails. Ron Chernow, writing for the New York Times, explained the aftermath like this in 2001:

“Think of the stock market in recent years as a lunatic control tower that directed most incoming planes to a bustling, congested airport known as the New Economy while another, depressed airport, the Old Economy, stagnated with empty runways. The market has functioned as a vast, erratic mechanism for misallocating capital across America.”

Many of those businesses went belly up, never to be heard of again, with trillions of dollars of Americans’ capital put to use in little more than a Ponzi scheme.

Chernow explains what inevitably happens following such maladroit capital allocation:

“Let us be clear about the magnitude of the Nasdaq collapse. The tumble has been so steep and so bloody — close to $4 trillion in market value erased in one year — that it amounts to nearly four times the carnage recorded in the October 1987 crash.”

And then there was the 2008 financial collapse on Wall Street – which produced the largest economic collapse in the U.S. since the Great Depression. That was also built on the dung heap of faulty pricing and misallocation of capital. Wall Street’s mega banks paid Moody’s and Standard & Poor’s big bucks to rate insanely structured pools of subprime mortgages and other bad debts and get AAA-rated credits to sell to investors, including public pension funds. These pools should have been rated junk from the beginning. The bad bets were packaged into Collateralized Loan Obligations (CLOs) and Collateralized Debt Obligations (CDOs).

The Fed rewarded this behavior by secretly handing out $29 trillion cumulatively in below-market-rate loans to these corrupted global banks for more than two years — with not a single vote held in Congress or even the awareness by Congress that the Fed was pumping trillions of dollars into insolvent banks on Wall Street.

Guess what the Fed is accepting today as collateral in its emergency loan program known as the Primary Dealer Credit Facility (PDCF): CLOs, CDOs, and stocks, as well as other toxic waste from the global banks that operate as trading houses on Wall Street.

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