By Lending More Broadly, the Fed Can Avoid Picking Winners and Losers

T he Coronavirus fiscal-relief package (the CARES Act) is clear on who will receive its much-needed payments, in the form of checks to individuals and expanded unemployment insurance plus relief for small businesses and certain industry sectors. But the rules governing the Federal Reserve Bank’s lending authority will severely limit the ability of some mid- and large-size businesses to obtain the financing they desperately need to get through the current economic shutdown.

On March 23rd, the Fed committed to “using its full range of authorities to provide powerful support for the flow of credit to American families and businesses.” The recently passed relief bill authorizes the Treasury secretary to provide a newly created Fed facility up to a total of $500 billion as collateral (loss protection), which the Fed can leverage to make around $4 trillion in loans. These funds are meant to assist businesses that are stressed because of the shutdown but do not qualify for relief under the CARES Act’s small-business provisions.

On the fiscal-policy side, small businesses with less than 500 employees can access $350 billion worth (likely to soon be expanded) of contingent loans doled out by the Small Business Administration (SBA). Those loans will be forgiven if the borrowing employer keeps people on the payroll. There are winners and losers in this package as well. Carve-outs in the CARES Act include SBA-forgivable loans for large restaurant and hotel companies (with under 500 employees per location as opposed to in total). There is also a financing gap for some startups and small businesses backed by or affiliated with venture capital. Private equity still cannot access the SBA-forgivable loans because of historical SBA rules.

The Fed also announced the details of its Main Street Business Lending Program  to support lending to eligible small-and-medium sized businesses that “were in good financial standing before the crisis,” complementing efforts by the SBA to support businesses with up to 10,000 employees and less than $2.5 billion in revenue. But it’s unclear how “good financial understanding” is defined and how solvency requirements will be applied, which could lead to the Fed picking winners and losers, leaving some without access to funds.

Section 13(3) of the Federal Reserve Act permits the Fed to make emergency loans to nonbank companies. However, after the unpopular financial bailouts, the then-Democratic-led Congress in 2010 amended the Dodd-Frank Act to prohibit the Fed from making loans to “borrowers that are insolvent” and “requiring that the Fed ensure ‘security for emergency loans is sufficient to protect taxpayers from loss.’”

The Fed then went a step further, subsequently issuing a regulation defining insolvency in a way that would further constrain its freedom to act. As a result, the regulations currently governing the Fed’s compliance with Section 13(3)’s solvency requirement state that any borrower who is “generally not paying its undisputed debts as they become due during the 90 days preceding the date of borrowing” is considered insolvent. At a time when the government has essentially shut down the economy, that 90-day requirement will be increasingly difficult for many companies to meet.

This means that far larger corporations — corporations that previously were paying their bills on time before COVID-19 but now find themselves distressed — may face problems thanks to new arbitrary Fed-facility rules.

Only companies with publicly issued corporate bonds that, as of March 22, carried investment grade credit ratings (“BBB” and above) can access the Fed’s new Primary Market Corporate Credit Facility and Secondary Market Corporate Credit Facility. Companies that don’t currently have at least two “BB-” credit ratings from agencies are ineligible; many companies are being downgraded well below “BB-” due to COVID-19. As of February, about 50 percent of all investment-grade corporate bonds were rated “BBB,” one notch away from falling below investment-grade status. Since the shutdown, rating agencies have been fiercely downgrading companies below junk, making them potentially ineligible.

By these arbitrary criteria, the Fed will now buy Ford junk bonds, which were downgraded to junk after March 22 — but not AMC and Cinemark junk bonds, since their downgrades to junk happened on March 16.

To expeditiously resolve these problems and expand crisis lending uniformly, the following actions should be taken.

First, Congress should amend Section 13(3) of the Federal Reserve Act to clarify solvency requirements and grant the Fed more flexibility in administering its Main Street Business Lending Program. The Fed could also use the Administrative Procedures Act to eliminate the way it previously defined strict solvency requirements for 13(3) emergency lending eligibility.

Second, Congress should pass legislation that waives SBA affiliation rules to allow companies with less than 500 employees backed by venture capital and private equity to access CARES Act SBA programs — conditional on not firing people. The Fed should also relax the lending requirements of its Main Street Business Lending Facility to cover loans below $1 million (giving more access to smaller borrowers), purchase 100 percent of the loans (rather than purchasing only 95 percent of each bank loan, leaving 5 percent with the bank) and consider making terms more attractive to banks and borrowers.

Third, the Fed should expand its corporate bond-buying programs move to move its eligibility date from March 22 to some earlier time — perhaps in February before all COVID-19 ratings downgrades — and loosen current credit-rating requirements to uniformly help more corporations in distress due to COVID-19. The Fed could also loosen the current AAA credit rating requirements for credit-card, auto-loan, and small-business-loan asset-backed securities that can be bought by its TALF program.

These measures may be controversial, inviting concerns over moral hazard. But the unprecedented and unique nature of a once in a century pandemic requires an unprecedented and unique response. The Federal Reserve should also want to avoid the mistake it made during the outset of the Great Depression when it contracted the money supply, prolonging the depression (as Milton Friedman and Anna Schwartz showed in their classic book, A Monetary History of the United States).

As each day passes, previously solvent businesses that were paying their bills before the shutdown and could survive the downturn are laying off or firing employees. They are unsure whether they will have access to credit sufficient to remain in business during this crisis. Many of those employers will need assistance to get through the shutdown without laying off or terminating those employees. That initial unemployment insurance claims over the past three weeks exceeded 15 million only heightens the urgency.