Special Notice 30

COVID-19 FINANCE:  A REVIEW AND ASSESSMENT

By William J. Dodwell    April 13, 2020

·       The 2008 financial crisis centered principally on the housing and financial sectors that spawned the subprime loan debacle in all its ramifications.  By contrast, the novel coronavirus crisis cuts across all economic sectors that produce and consume goods and services.  What’s more, the economic impact is more extensively global than the Great Financial Crisis.  Hence, the historical scale and scope of the fiscal and monetary stimulus implemented by the U.S. Treasury and the Federal Reserve Bank.

The genesis

Government-mandated lockdowns to contain the spread of the COVID-19 virus have frozen the national economy.  As a consequence, businesses, as well as states and municipalities, have to frantically raise cash to cover operating losses and debt service in the face of dramatic revenue shortfalls. And in the process, tens of millions of furloughed workers lose their income.  What’s more, investors, besides liquidating stocks, initially generated a massive sell-off of Treasuries that led to serious illiquidity throughout the credit markets shutting off desperate borrowers. 

Then the Federal Reserve rode to the rescue with a mammoth liquidity infusion that has stabilized the credit markets, and might have started a growing investor rotation from bonds back to stocks.  In addition, ultra-low interest rates attendant to the new liquidity prompt extensive business borrowing to raise cash. 

The Fed stimulus      

The Fed, with the help of a $30 billion equity investment from the Treasury’s Exchange Stabilization Fund, has provided a $2.3 trillion package of loans in response to the economic ravages of the coronavirus crisis.  All loans are issued by banks which can sell them to the Fed while retaining a required 5% interest.  Fed accommodations include the following:

-        A 1% cut in the benchmark interest rate to near zero.

-        Additional lending to the financial sector through more reverse repurchase agreements.

-        Expanded securities purchases (quantitative easing) beyond traditional Treasuries and agency mortgage-backed securities, now to include municipal bonds, as well as below-investment grade corporate bonds and ETFs.

-        Loans to businesses with up to 10,000 employees and less than $2.5 billion of 2019 revenue, along with a one-year deferral of principal and interest payments.

-        Purchases of corporate commercial paper to backstop inadequate market participation.

-        Loans to finance investor purchases of AAA rated asset-backed securities through the Term Asset-Backed Securities Loan Facility (TALF). This program, revived from the 2008 crisis, supports the securitization of auto loans, credit card receivables, trade receivables, leases and student loans affecting a cross-section of economic activity.  The facility also finances the purchase of AAA commercial mortgage-backed securities (CMBS) and collateralized loan obligations (CLOs).

-        Temporary relaxation of a regulatory capital requirement; banks may omit Treasuries and central bank deposits from the leverage ratio (core capital/assets).

        The Treasury stimulus

        At the same time, Congress passed the Coronavirus Aid Relief and Economic Security Act (CARES), a $2.2 trillion initial spending and loan package for             individuals, municipalities, and businesses of all sizes to reignite consumption and production. It includes the following:

-        A one-time cash payment of up to $1,200 to workers and retirees.

-        Bank loans to small businesses to finance payroll that are forgiven if employees are retained..

-        Bank loans guaranteed by the SBA to shore up operations.

-        Payroll assistance and loans to the hard-hit airline industry, partially in consideration of disputed stock warrants.

-        Loans to states and local governments serving populations over 500,000.

-        Expanded unemployment benefits, some of which match or exceed lost salaries. 

And more is coming, subject to Democratic extortion to add sundry unrelated special-interest spending.  President Trump has proposed an additional $250 billion for small business. Also under discussion is a proposal for guaranteed private company paychecks.  The Treasury, that is taxpayers, will absorb defaults of its loan, as well as those of the Fed.  But even with government aid, companies face a liquidity squeeze from radical revenue declines.  CFOs are issuing bonds, extending credit lines and cutting costs to get by.

How is so much government debt affordable?  Financial markets presume that the historical good faith and credit of the U.S. government always will attract global investment in Treasuries and thus enable federal borrowing on demand at reasonable cost.  In addition, the Fed has always been able to create money by fiat to ensure currency with which to buy the debt while usually avoiding serious inflation through robust economic growth.  Witness the dramatic rise in federal debt to fund the wars in Iraq and Afghanistan, as well as the recovery from the 2008 financial crisis.  While the COVID-19 emergency may justify the current government extravagance, and the inherent power of the economy permits certain excess, there is a limit to a nation’s means and the ability to live beyond it. Too much moral hazard is dangerous in a free market economy.

Inflation

At some point the new liquidity could unleash dangerous inflation. Surprisingly, it did not materialize from the monetary stimulus following the 2008 financial crisis.  That is because that money redounded to the financial sector creating inflated financial assets instead of overpriced goods and services in the real economy as investors sought to escape near-zero interest rates.  (Also tempering inflation have been global competition and productivity from technological advances and deregulation.) But in the long-term that capital will migrate from the financial sector to the real economy, perhaps to create inflationary pressures.    

But the multi-trillion dollar coronavirus monetary and fiscal stimulus is more targeted to industry and impacts all sectors of the real economy making eventual goods inflation seemingly compelling.  In the extreme, this would engender growth-stifling taxes and interest rate hikes that could lead to government and corporate ratings downgrades and more burdensome debt service.  Highly indebted companies that cannot roll over coronavirus debt could precipitate widespread defaults and bankruptcies that further suppress the economy. On the other hand, some additional inflation would be salutary in that it eventually forces up interest rates to normal levels.  That outcome has eluded the Fed for over a decade.

Recovery

The coronavirus bailout and GDP decline will likely raise the federal debt to GDP ratio to approximately 120%, up from about 40% before the Great Financial Crisis.  At the same time, demands on Social Security and Medicare escalate sharply as legions of baby-boomers retire.  One has to wonder how much all this fiscal drag will affect future growth.  And conservatives worry about the increasing interventions of the Fed and Treasury in the private sector that foster growing dependence on government, and perhaps a societal appetite for socialist policy.

Pre-crisis prosperity and the government backstop against coronavirus losses during the downturn suggest the economy’s ability to rebound fairly quickly in the short-term in a V-shaped or U-shaped recovery.  But, while pent up demand will create an initial spark, some consumers may hold back until they make up lost income.  Likewise, some employers may not rehire all employees as a cost-saving measure. In addition, depleted investment portfolios may have a reverse wealth-effect that deters normal spending.  If these factors combine with a recurrent coronavirus outbreak, a longer term W-shaped recovery is more likely.

More importantly, the long-term outlook could be plagued by growth-sapping deficits and debt, taxes, suppressed corporate earnings and muted stock valuations that preclude a return to normalcy that was the Trump economy.  The solution is a strong pro-growth agenda that supports investment and innovation, principally through tax incentives and regulatory relief.  But that prospect is doomed if President Trump is not reelected in November. In any case, government spending has to be reigned in significantly to generate the growth that can enable meaningful debt reduction.  No president has been inclined to do that for some time

©2020 William J. Dodwell



             William J. Dodwell is a retired corporate executive, management consultant and financial writer in the finance industry with particular expertise in the                     capital markets.  Mr. Dodwell has written in professional journals, the trade press and corporate publications. He is a Certified Public Accountant                             (Inactive) licensed in the State of New York. 


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