Global firms are making money on virus crisis

WASHINGTON — Pacific Investment Management Co. runs a hedge fund registered in the Cayman Islands, a common structure for avoiding certain U.S. taxes. But when a profit opportunity arose from the ashes of America’s coronavirus crisis, that international location did not stop it from seizing the moment.

The Federal Reserve opened a highly anticipated emergency lending program in June, a revamped version of one it used during the 2008 financial crisis. This time around, Congress stipulated that only American companies could participate as borrowers in such programs. Despite being offshore, Pimco’s fund had an easy way to benefit.

The offshore fund is invested in an entity registered in Delaware. That entity can be used by investment managers to buy and sell bonds. The Delaware operation borrowed $13.1 million from the Fed program by pledging a bundle of debt as collateral. Investors in the Cayman-based hedge fund ultimately stand to profit from the transaction.

The Pimco example is not unique — other foreign investors have put money into U.S.-based funds that are tapping the Fed program. That they found a way to participate in a program restricted to American borrowers highlights the potential for financial firms to make money from the Fed’s market rescue programs, even if doing so means maneuvering around congressional limitations on eligibility. Investors earned double-digit returns on the program during the 2008 financial crisis, and they stand to profit this time around as well, as they collect interest on the debt bundles and, thanks to the Fed’s cheap funding, pay very little to hold them.

The Fed’s program is intended to keep credit flowing through the economy, but its design has provided an opportunity for global financial players to profit from an initiative backed by taxpayer funding. That side effect could draw further scrutiny to the Fed’s rescue efforts, which are already prompting questions from lawmakers about who benefits, and on what terms.

The goal of the Fed program in question — known as the Term Asset-Backed Securities Loan Facility, or TALF — is to bolster a critical corner of U.S. debt markets, one where loans are bundled and sold off to investors who are willing to take on risk in exchange for interest payments. That helps to keep the market for commercial mortgages functioning and allows student loans and credit card debt to continue flowing to end-users.

The program was not created to make money for investment vehicles or the investors they represent. But because of the way TALF works, financial firms like Pimco’s hedge fund can make a profit from it.

It operates by encouraging investors to purchase a certain type of debt called asset-backed securities. A fund can buy those securities using some combination of cash and short-term loans and then take them to the Fed in exchange for a TALF loan.

The TALF loan can be used to pay back whatever money the fund borrowed to make the purchase in the first place, so that its holdings are financed mostly by the cheap Fed loan and a sliver of its own money (what is known as a “haircut” in financial parlance). It essentially earns the difference between what it makes in interest from the securities and what it is paying on the Fed loan.

Because investors have just a small amount of money at stake, returns on each invested dollar can be quite high. Investors said they anticipated high single-digit returns in 2020, far lower than the double-digit returns in 2008 but still generous.

The Fed has so far released detailed data only on TALF’s first round of loans, although the program has since finalized two more rounds. The Fed will most likely release additional data in mid-August.

Pimco’s Cayman Islands-based fund, which has borrowed via a U.S.-based entity called TOCU IX, is one of several foreign investors using an American investment vehicle to gain access to TALF. The pension plan of the Oxford University Press Group will tap the program through a fund set up by New York-based investment manager MacKay Shields. A Singapore-based fund is a material investor in an offering by the giant financial firm BlackRock, according to the Fed’s first round of detailed disclosures.

The fact that some investors based overseas can make money from TALF does not break Congress’ rules, but it may fall shy of what some lawmakers intended. They specified that loans, advances and asset purchases made under the Fed’s programs should be restricted to “businesses that are created or organized in the United States or under the laws of the United States.” But they said nothing about who could ultimately benefit.