The COVID-19 pandemic has led to an unprecedented shutdown of workplaces and schools, and a rapid rise in unemployment. The Federal Reserve moved aggressively in early March to support financial market functioning and the flow of credit to households and businesses. The Coronavirus Aid, Relief, and Economic Security Act (CARES), signed into law by the president at the end of March, allocates funds for health care to help to contain the spread of the virus and for payments, grants, and loans to workers and businesses who have been harmed by its economic fallout.
The Fed moved more quickly and is providing liquidity to a broader set of financial markets than it did in the global financial crisis a decade ago. A significant expansion is still to come, with a Main Street Business Lending Program to support lending to small-to-mid-sized borrowers facing temporary financial difficulties, but this program raises new challenges.
The profound uncertainty at the onset of the pandemic about damage to the economy up-ended critical financial markets. Investors could not rely on usual risk-return assessments to make decisions. With credit flows threatened, the Fed cut interest rates, set up programs to provide liquidity to support the financial system, and announced macroprudential policies to ease financial regulatory constraints. It escalated in all these dimensions in subsequent weeks. While these actions cannot substitute for relief that only Congress can provide, they will limit the depth and duration of the recession and position the economy for a quicker recovery when the pandemic recedes.
More Aggressive Than in 2008
The actions the Fed has taken are more aggressive than in 2008.
First, they were quicker. The virus shut down economic activity with remarkable speed. In 2008, while stresses were evident in financial markets in late 2007, employment and GDP growth did not plummet until a year later when Lehman failed. In addition, the Fed learned from the previous crisis that taking actions earlier rather than later improves the potential for good macroeconomic outcomes, by reducing the odds that adverse dynamics will take hold. Moreover, the Fed drew on the 2008 playbook for lending programs. In March, the Fed announced more than five emergency liquidity facilities under section 13(3) of the Federal Reserve Act; most were identical or similar in design to 2008 facilities. The Fed had another advantage this time: In 2008, decisions were very difficult because supporting the flow of credit meant helping actors in the financial system that caused the crisis. This time the cause is external, and responses are largely uncomplicated by moral hazard issues.
Second, they were broader. The Fed has expanded the reach of its emergency liquidity to more credit markets and assets, specifically medium-term investment-grade corporate credit and short-term high-rated municipal credit. A new Primary Market Corporate Credit Facility (PMCCF) is available to investment-grade borrowers to access funds by issuing bonds or loans of less than four years at a credit spread above usual market conditions, though below recent spreads. The PMCCF offers more durable funding to businesses than commercial paper and draws on credit lines at banks. The Secondary Market Corporate Credit Facility (SMCCF) takes a big step beyond the primary market. The Fed will lend to a facility capitalized by the U.S. Treasury and will purchase investment-grade corporate bonds and bond ETFs that hold investment-grade corporate bonds in the secondary market. While the Fed’s Primary Dealer Credit Facility (PDCF) can influence the secondary market because dealers can post corporate bonds as collateral, the SMCCF is a more direct intervention. The SMCCF term sheet states that this facility is intended to support market functioning and promote the transmission of monetary policy. Still, it is unclear how that intended purpose will translate into a strategy for what to purchase, and when and whether it will also be a seller.
The Fed also has broadened its reach to short-term high-grade municipal securities in the Commercial Paper Funding Facility (CPFF) and the Money Market Mutual Fund Liquidity Facility (MMLF). Municipalities that had issued commercial paper or other short-term notes prior to the onset of the pandemic will be allowed to issue three-month paper to the CPFF at a spread to the overnight index swap (OIS) of 110 basis points. In addition, state and local governments will benefit from the Fed’s offer to lend to banks that purchase short-term debt or variable-rate demand notes (essentially long-term municipal bonds that reprice at short-term intervals) from tax-exempt money market mutual funds (MMFs). These MMFs have been facing significant withdrawals as investors have fled to the safety of banks or to funds that invest primarily in Treasury securities.
In contrast to 2008—when concerns about the solvency of major financial firms were significant—the Federal Reserve can now look to the banks to support credit because they are starting from a stronger position. Importantly, it is encouraging banks to draw on the significant capital and liquidity buffers they have built-up in the past decade if lending and other actions are taken in a safe and sound manner. Moreover, the largest banks are suspending stock buybacks through the second quarter to preserve capital. More usable capital and liquidity are important to ensure that banks can continue to extend credit and that the fiscal relief and central bank liquidity actions can flow through to borrowers in need of funds. In addition, the Fed and other federal banking regulators have issued guidance to banks to encourage them to modify loans, such as deferring payments or extending maturities for six months, for household and business borrowers with temporary difficulties because of COVID-19. Such modifications made will not be viewed as reflecting a borrower “in distress,” and thus would not require banks to reduce capital immediately for higher expected losses. These actions to help borrowers through temporary disruptions should help the borrower, lender, and the broader economy.
Main Street Lending
Even with the speed and expansion to more assets, the Fed should do more for small- to mid-sized businesses. The Fed said that it expects to announce soon a Main Street Business Lending Program. This program would complement the Payroll Protection Program in CARES, which are loans to be made in a Small Business Administration (SBA) framework to businesses with less than 500 employees. Some portion of these loans may be forgiven if the business meets certain conditions related to retaining employees. The SBA is expected to issue guidelines this week to expand the number of authorized lenders in order to expedite the expansion of these loans.
The Main Street Business Lending Program to support loans to small- and mid-sized borrowers will represent another significant expansion of Fed programs. The potential universe of borrowers is large: there are almost 6,000,000 businesses with fewer than 500 employees, and another 18,000 businesses with between 500 and 5,000 employees, according to the Census Bureau. Even if it were executed solely through discount window lending to commercial banks, based on existing relationships that banks have with their local borrowers, it would be an expansion of the Fed’s efforts because the intent is to make funds available on favorable terms. Alternatively, the program could be structured in a credit facility similar to the CPFF or PMCCF structures, which could potentially also include loans made by nonbanks.
Whatever the structure, the Fed and Treasury will need to consider a number of important issues related to its own objectives, and those of the borrowers and lenders. A key issue is how much risk the Treasury, as agent for the taxpayers, is willing to take, given the 13(3) requirement that Fed lending is secured to its satisfaction. This determination will determine how many businesses the program can help. Expected loss rates on small business loans are much higher than on loans to large corporations, and the variance is much greater. Another issue is establishing underwriting criteria to help distinguish businesses that are viable but temporarily short of income from those that may no longer be viable even in an economic recovery. Making loans to businesses that are not viable merely increases their debt burdens and could harm the businesses the Fed is trying to help and hinder the speed of the broader economic recovery. A third issue is balancing the incentives provided to lenders to quickly get funds to businesses, while at the same time protecting banks from possible future risks of many costly loan workouts if many borrowers cannot make their payments or repay their loans.
The experience of the 2008 financial crisis taught policymakers that aggressive interventions can limit the size of the recession and reduce long-lasting damage. Many Main Street businesses need credit to retain employees, while social distancing remains the primary way to reduce the spread of the virus. This circumstance requires that the Fed and Treasury expand well beyond their more familiar approach to supporting corporations that have access to capital markets. But with the cooperation of lenders, it will be possible to get the funds made available in CARES out quickly to the small businesses that would benefit most, while protecting taxpayers.