Brownstein Client Alert, April 6, 2020
The nation’s health crisis is our collective primary concern, but a financial crisis of unparalleled proportions is close on its heels. A significant number of household brand companies that are deeply woven into the fabric of American culture are on the precipice of Chapter 11 bankruptcy. If that happens, companies whose names you know and love—movie theaters, mall retail anchor tenants, hospitality and recreation companies—as well as local childcare centers, restaurants, and other small businesses will shutter stores and venues and either thinly operate the balance of their enterprises or never re-open. Revitalization efforts in Cleveland, Detroit, and other major American cities will come to a grinding halt; the iconic profiles of New York, Nashville, and Las Vegas will be imperiled. Rural America, rich in entrepreneurial spirit but with persistent economic development challenges of its own, will likely be the first to suffer and last to recover. At this moment, math and politics are about to clash.
As members and staff during the post-2008 financial crisis recovery period, we know that bipartisan leadership is the key to economic recovery. Right now, the stakes could not be higher. Congress has taken a bold first step in appropriating $454 billion to the Treasury Department, which will capitalize one or more business loan programs that the Federal Reserve will establish, but very soon there will be an urgency to do more. The Federal Reserve will supply some multiple of the $454 billion in leverage—essentially the “debt” of the lending fund to complement the Treasury’s “equity” contribution. The big question for lawmakers and the agencies is how much leverage will be supplied and whether the resulting lending program’s eligibility rules and size will provide meaningful help to the majority of American businesses in every state and congressional district.
The math behind the Federal Reserve’s contribution is a function of a handful of considerations, but the primary driver is the lending program’s credit eligibility rules. The Federal Reserve will not take on material credit risk. So, if the “credit box” allows companies with only investment-grade ratings profiles to borrow from the fund, the Federal Reserve will contribute more leverage to the fund because the risk of credit loss will be relatively low. This result would generate a large lending fund but would not be available to many household brand names that are rated BB and lower or not rated at all. On the other hand, if the credit box is wide and allows lower-rated and unrated companies to borrow, the Federal Reserve will contribute less leverage because the risk of credit loss is comparatively higher. The fund would be available to all businesses but the size of the fund may not be large enough to accommodate all credit needs.
Other considerations will bear on the size of the fund, too. The Federal Reserve is no doubt right now performing stress tests on corporate America as a whole. They are looking through historical data on the frequency of corporate defaults on debt and the recovery rates (how many cents on the dollar are recovered in a company’s bankruptcy). They are considering whether loans to companies should be secured, and therefore a “safer” bet for the Federal Reserve, or unsecured—a decision not predetermined by the CARES Act. The Treasury and Federal Reserve are also looking at other needs in the economy, such as municipal bond liquidity and unclogging the financial “plumbing” of the capital markets that finance a significant amount of American lending, for which the agencies may decide to use some of the $454 billion, thereby reducing the amount of Treasury “equity” for corporate lending.
We believe that Congress, in a bipartisan manner, urgently needs to signal to Treasury and the Federal Reserve that the legislative branch’s political preference is that the corporate lending program should help a broad swath of businesses from the get-go, even if that means more appropriated money is likely to be needed in the “Phase Four” bill. Numerous members of Congress have publicly stated that the COVID-19 recovery should not pick winners and losers. The Treasury and Federal Reserve, neither a directly elected branch of government, are ill-suited to make such a decision by drawing eligibility lines that save some companies but let others wither on the vine. Congress is more appropriate to take the leadership role and give public signals about its future intentions to further capitalize the Treasury-Federal Reserve apparatus.
Some of our former colleagues will raise the “moral hazard” issue in the context of arguing that the government should not “bail out” more leveraged companies. But there is moral hazard in not providing assistance to these companies—namely, that government creates in corporate America an implied expectation that Main Street companies retain a “coronavirus capital” buffer on their balance sheets in preparation for the next pandemic’s financial fallout. Consider the foregone investment in innovation, expansion, and hiring that would occur if businesses sidelined huge amounts of cash in good economic conditions just to be able to weather the next downturn. The answer to the moral hazard question is probably somewhere in between; we just went through this exercise over the last 10 years with the banking system. But it is a debate that should be had once our nation comes out of this crisis, not now. Besides, any help these companies may receive is to help survive necessary, government-ordered shut-downs to prevent the spread of disease, not to patch over imprudent risk-taking.
Math aside, behind every closed store and shuttered business there are human stories: workers who will lose their jobs, public workers whose pensions will be risked, family companies that will see their invested life savings wiped out. Every senator and member of Congress is hearing from these constituencies hourly. We have heard from many members of Congress who are not in the weeds on the Federal Reserve’s mathematical models that they do not know what to do to help their constituents. The handful of Federal Reserve and Treasury officials who are busy around the clock writing these programs to get money out the door as fast as possible do not have time for phone calls from 500 elected officials. One way members could help is to develop bipartisan consensus that all businesses should be assisted, coalesce around whether and when additional appropriations will be forthcoming, and to communicate these intentions publicly to the Federal Reserve, Treasury, and corporate America.
It is also critically important that Congress and the Federal Reserve address the Federal Reserve Act’s prohibition on Federal Reserve lending to an “insolvent” entity, which is defined, in part, as a business that is generally not paying its debts as they become due. Many businesses are skipping April rent and mortgage and are stretching trade credit lines, which may make them ineligible for corporate loans from one or more Federal Reserve lending facilities capitalized with the $454 billion CARES Act money. Every option should be on the table.
The stakes have not been this high since the years following the Great Depression. Then, Congress’s choice was to go big and bold. The New Deal provided stimulus to the economy at a time when it was needed; people reasonably debate the efficiency of those programs as enduring institutions. Whether Main Street America’s businesses make it through the COVID-19 recession will turn on whether bipartisan leadership in Congress, working with the Treasury and Federal Reserve, can solve the credit box conundrum.
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