'Money washing': Here's how the Federal Reserve is bailing out big corporations and Wall Street banks

'Money washing': Here's how the Federal Reserve is bailing out big corporations and Wall Street banks
Governor Jerome H. Powell testifies before a joint hearing of the Senate Banking Subcommittee on Securities, Insurance, and Investments and the Subcommittee on Economic Policy in Washington, D.C., on April 14, 2016.

Money laundering is a dirty word. Shady characters move illicit wealth to make it look legitimately gained. Think “Breaking Bad,” but for embezzlers, extortionists and tax evaders as well as drug traffickers.

Regulators, mostly in the United States, fined large banks almost $10 billion over a recent 15-month period for violating anti-money laundering rules.

Now we’re seeing a new kind of activity involving hiding the real value of money held not in greenbacks but in the usually more durable paper known as corporate bonds.  In the end, you will almost certainly pay the price as your 401(k) or other retirement or investment account gets dinged and perhaps deeply gouged for the immediate benefit of big Wall Street clients.

Now, think of a variation of money laundering that we’ll call money washing. Instead of trying to cleanse away criminality, money washing removes a kind of financial dirt that reduces the value of corporate bonds just like dirt reduces the value of most other things.

Unlike money laundering, this new technique is perfectly legal.

Pretend that last year you bought a single bond from a company with a sterling financial record. You paid $1,000 and expected to collect interest for 20 years and then get your $1,000 back.

Then, the coronavirus came this year and the company’s revenues have shriveled. The likelihood that you will ever get your full $1,000 back, let alone all the interest payments, has gone from near certainty to highly unlikely.

A Money-Back Guarantee

You could sell your bond but, understandably, buyers won’t give you $1,000 for it. Whether you get a discounted price of $990 or $900 or just $90 will depend on how Wall Street traders rate the chance of recouping the interest and principal from the company.

Now, a buyer comes along willing to pay you the full $1,000. If you’re smart, you sell the bond, take the cash and run.

If you were not just smart but big enough and rich enough, you’d buy all the bonds you could at those discounted prices, sell them to this generous (or crazy) buyer at $1,000 each and turn a quick guaranteed profit.

While you don’t have the money to buy up millions of these distressed bonds, Wall Street does.

Ladies and gentlemen meet this generous (or crazy) bond buyer: The Federal Reserve.

The Fed has been visibly panicked by the economy plummeting.

‘Investment-Grade’ vs. Junk

Since March 23, the central bank has been buying high-grade corporate bonds issued by companies with a solid history of paying their debts. Think household brand names.

Fed purchases of those quality bonds inject dollars into the economy. That provides banks, businesses and pension plans with cash to pay to employees, retirees and vendors. This bond-buying spree is officially unlimited. It will be multiples of the Fed’s bond purchases in the depths of the Great Recession just a few years ago.

The Fed did restrict the exchange of corporate bonds at their full face value for dollars to what’s known as investment-grade debt. Investment grade means the face value of the bond and the interest are likely to be paid on time and in full.

Last week, the Fed did what was previously unthinkable. It started buying bonds now worth far less than they were just weeks ago—some of the riskiest corporate debt in existence. It started buying junk.

Fallen Angels

When investment-grade companies get into trouble their credit ratings drop—as happened with the likes of FordMacy’s, and The Gap as sales collapsed due to the coronavirus. Companies in this situation are called “fallen angels.” These once sound companies—which suffer in part from bad past decisions like overexpansion and highly leveraged acquisitions—find themselves in need of raising money just when their borrowing costs increase because lenders demand higher interest rates. That’s a prescription for unhealthy finances.

When corporate credit ratings fall, the bonds these companies issued in the past start to trade at lower prices because of the increased risk that bondholders will not be paid off in full.

So, what happened when the Fed said on Thursday that it would pay good money for risky bonds? Deeply discounted Ford bonds jumped 22% overnight by midday Friday. Other junk debt suddenly rose in value, too, as savvy Wall Streeters cashed in by buying bonds cheap and selling them at their much higher face value.

Legal Loan Sharking

While once-solid bonds issued by companies like Ford have fallen to junk status, there also exists a market for risky corporate debt on the day that bonds are sold. In personal deals, we call such lenders loan sharks and make their activity a crime. In the corporate world, however, we call the sellers of these risky loans investment banks and declare it legal.

Because junk bonds are sold with a significant chance of never being repaid in full, buyers insist on high rates of interest. Junk bonds are currently yielding investors more than 8% annually compared with as little as 2% on the most trustworthy corporate debt and less than 1% for some U.S. government debt.

Junk bonds were popularized in the 1980s by Michael Milken, the financial manipulator who went to prison after he confessed to six securities fraud charges. The companies that turned to Milken to sell their junk bonds were seen  by banks as unworthy of loans.

Junk bonds financed Donald Trump’s brief and personally lucrative rise in the Atlantic City casino business. He walked away with hundreds of millions while buyers of Trump’s junk bonds lost their shirts. Trump’s worst bonds were sold in 1990 by Merrill Lynch, now part of Bank of America.

Many Hazards

Maybe this Fed move to swap damaged paper for clean cash is necessary to stave off a Great Depression 2.0. But it has predictable consequences.

One is that corporations and high net-worth individuals, who are supposed to understand the risks they take, escape the consequences for their decisions. That’s a form of socialism for the rich and corporations, but it’s also the smallest problem.

Next is “moral hazard.” When companies get bailed out, they began figuring they can keep doing what they’ve always done, even if dangerous and risky. This encourages more and worse risky behavior instead of prudence.

“As painful as failure and recessions are, we keep putting bigger and bigger band-aids on our problems, expecting them to change,” says Craig Kirsner, president of Stuart Estate Planning Wealth Advisors in South Florida. “When will we learn?”

Given past performance, apparently never.

‘Fictional Value’

Another problem is that ordinary investors will have no idea what their investments are worth without Fed props. “It’s fictional value,” says Allen Sukholitsky, chief macro strategist for Xallarap Advisory in New York. “It’s not fact-based.”

That problem worsens as the props may not stop. Like a junkie needing larger doses of a drug to get high, markets will require ongoing and larger intervention for satisfaction. The result is a dilemma because market capitalism depends on reliable price information.

Price is crucial to a market economy as opposed to one run by the government, as in the old Soviet system. While people have an idea of what a gallon of gas or milk or distilled water costs from experience, without deep education in finance and accounting they have no independent way to value the stocks, bonds and other financial investments in an era of self-managed retirement savings.

This Fed interference with market prices infects more than bonds. Sukholitsky noted that you might eventually see higher prices at the grocery store in the future. As the Fed artificially inflates the value of assets like troubled corporate bonds, there’s additional perceived money to pay for products so sellers raise prices to capture more of the value.

The ultimate irony is the wealthy regularly lecture those who aren’t about responsibility and actions having consequences while getting their own bailouts.

This is a real American exceptionalism: Everyone wants their own exceptions, but only the select get exceptional Fed favors.

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