Financial Positions of U.S. Public Corporations: Part 5, The Main Street Lending Program: Potential Benefits and Costs
This blog post1 is the fifth in a series that discusses how the current pandemic affects the financial positions of publicly traded U.S. corporations, the potential implications of these financial developments, and the federal policy response.
In this post, we study the economic benefits and costs of the Main Street Lending Program, created by the Federal Reserve to support corporations during this crisis. We make four points, which reflect our analysis and are not the views of the Federal Reserve System or the Federal Reserve Bank of Chicago. First, the main potential benefit of this program is to supplement private funding to corporations so that they can avoid financial distress during the pandemic. Private funding may be insufficient either because financial intermediaries’ ability to lend is limited or because the intermediaries do not take into account the broader benefits associated with lending to distressed firms. Second, while the program is quite large, so that it has the potential to provide credit support to many firms, its potential might not be fully realized because all parties involved (borrowers, banks, and outstanding creditors) may not always have sufficient incentives to participate. Third, the program excludes some firms, which may limit its efficacy. And fourth, it is possible that the program may help the economy in the short run but marginally slow economic growth in the medium run by increasing debt overhang for participating firms.
Key Fed actions to support the flow of borrowing
As we discussed in an earlier post, the current pandemic has created a large cash flow shock for many firms, which need to raise substantial new funding, on top of rolling over their existing debt, to survive the next few quarters.2 The Federal Reserve (Fed) has taken various actions to facilitate credit flows.3 In this post, we focus on the potential economic effects of one major new initiative, the Main Street Lending Program. This program consists of three facilities,4 which have in common that banks underwrite loans for U.S. businesses and then sell a portion of the loan to an entity (a special purpose vehicle, or SPV) that is funded by the Treasury and the Fed. (Informally, the Treasury funding serves as credit protection for the Fed; to put it another way, it is the “equity,” while the Fed funding is the debt.) The official sources of information, providing all the program details, are here and here. Table 1 provides a high-level summary of some of the key features of the three facilities in the program.
The Federal Reserve also recently created the Corporate Credit Facilities, which also aim to support credit flows. These facilities will primarily serve the largest public firms and operate through credit markets by purchasing new or existing corporate bonds, as well as new syndicated loans. While some of our discussion also applies to the Corporate Credit Facilities, we do not discuss these in detail here. More information on them can be found in this blog post from the New York Fed.5
Why support financial intermediation and corporate credit markets?
What is the purpose of these lending programs? Why support credit flows? Why not, instead, simply let private borrowing—through banks and financial markets—fund firms as needed? After all, firms that are suffering from a temporary shortfall because of the pandemic, but are still solvent, should be able to borrow without any need for government intervention. In our view, there are two main reasons why these actions could be justified and productive.6
First, financial intermediation and financial markets might not be functioning appropriately in these unusual circumstances. For instance, while banks currently have ample capital due to the financial reforms that followed the Great Recession, their lending capacity might not be sufficient given the unusually large needs.7 Credit markets were also disrupted in the early stages of the crisis: The cost of credit for “high-yield” (riskier) corporations experienced a very rapid spike from March 3 to March 23, making it potentially difficult for these companies to obtain funding exactly at the time when it was most necessary. This increase likely reflected, in part, balance sheet constraints at financial intermediaries.8
Second, financial intermediation and financial markets, even if they are functioning normally, might under-provide credit in the current situation. There are several reasons for that. Most importantly, some of the gains from reducing inefficient bankruptcies would accrue to employees, customers, suppliers, or outstanding creditors, rather than to a firm’s new lender—i.e., the institution providing the additional credit. This implies that new lenders might be reluctant to extend credit, since they do not take into account these benefits when lending. Another reason is that there might be macroeconomic externalities from lending (for instance, aggregate demand externalities). And yet another reason is that there might be health externalities, to the extent that lending allows companies to take better precautions against the virus. All these factors suggest that offering credit at better terms than the private market could help preserve jobs, the economy, and health.
1. Stylized description of the Main Street Lending Program (as of June 8, 2020)
|Main Street New Loan Facility
|Main Street Priority Loan Facility
|Main Street Expanded Loan Facility
|U.S. businesses with fewer than 15,000 employees or $5 billion 2019 revenue
|LIBOR (1 or 3 months) + 300 basis points
|Size of programs
|Up to $600 billion across the three facilities, with $75 billion equity participation from the Treasury
Is the scale of the program sufficient to meet firms’ needs?
While it is difficult to estimate confidently firms’ funding needs, we believe the program is sufficiently large to meet these needs. Currently, the Main Street Lending Program has been funded with a $75 billion equity contribution by Treasury, which the Fed can in turn leverage up to $600 billion. Moreover, the Corporate Credit Facilities can provide up to an additional $750 billion.
To put these numbers in perspective, consider the following facts. First, the aggregate annual before-tax cash flows (“gross operating surplus”) of nonfinancial businesses is around $6.6 trillion.9 So, if the goal is to cover lost earnings, the Main Street program and Corporate Credit Facilities can together cover about 2.5 months worth for all businesses, both public and private. (Of course the pandemic-induced economic shutdowns will last longer than this, but then again some businesses are not drastically affected by the pandemic.) Second, in a previous post, we estimated funding shortfalls specifically for public firms and found that the cash crunch could be fully offset if public firms stopped all capital spending. If we take this as a rule-of-thumb—erasing the cash crunch is equivalent to stopping all investment—and apply this to all nonfinancial businesses, the amount needed to offset the shortfall is about $2.4 trillion.10 Hence, by this estimate, the Main Street program and the Corporate Credit Facilities jointly cover about half ($1.35 trillion) of the amount needed by all firms (public and private).
Two points must be taken into account. First, the scale of these two programs could potentially be expanded significantly if necessary: Treasury can decide to commit more of the funds appropriated under the CARES Act, which included $454 billion for credit support to businesses, states, and municipalities. Second, private lending is also taking place, so the programs are not required to cover all needs. Thus, overall, the scale of the programs seems roughly sufficient to meet most of the funding gap.
However, some features of the Main Street Lending Program may limit take-up
A key risk in the short run is that the program may fail to reach businesses that would benefit from receiving credit support. The main reason is that for a loan to be issued, the borrower, the outstanding creditors, and the lender, all must act—and their incentives might not always be aligned.
- Firms may not want to participate because of the strings attached to the loans.
The financial terms are capped: The interest rate that firms have to pay is set at a relatively low level (LIBOR + 300 basis points) and the fees are rather limited (borrowers must pay 75 to 100 basis points to the bank, and the bank must pay a 75 to 100 basis points participation fee due to the SPV, which it can pass through to the borrower; see table 1).11 These terms may entice participation of the firms (and as we discussed earlier, there are some plausible rationales why this credit should be subsidized). However, in order to obtain funding from the Main Street program, borrowers must also comply with several restrictions. Some significant ones are: First, they must suspend stock repurchases and dividend payouts until one year after the loans have been repaid. Second, they must follow certain limits on employee compensation set out in the CARES Act.12 Both of these provisions are meant to prevent the funding provided by the loan being diverted to equity owners or executives, but of course this limits the incentives for these actors to participate. Third, they must also make a “commercially reasonable effort to maintain employment.” Fourth, firms cannot use the Main Street program to repay outstanding creditors. (Absent this provision, banks would have an incentive to issue new Main Street loans to their riskier borrowers to allow them to repay their outstanding loans—reducing banks’ risk at the expense of the Fed facility.13 Loans issued through one of the three Main Street facilities, the MSPLF, are exempt from this restriction when they are issued, however, and allow refinancing; however, the loan being refinanced must be to a bank different than the one underwriting to the new loan.) Overall, these conditions, while they have their justifications, may deter participation. Finally, some firms may prefer to avoid taking on debt because that would make them insolvent—i.e., they cannot afford to add a debt repayment to their costs once the recovery starts. (For these firms, only a grant would allow them to survive.)
- Banks may not be eager to participate because of limited profitability.
The Main Street program relies on banks to underwrite loans, because they have the expertise to evaluate borrowers. But this in turn requires the program to provide banks with incentives to underwrite “good loans” (i.e., to firms that can plausibly repay the loan once the economy recovers), while avoiding having them pass on “bad loans” to the Fed facility. How does the program try to achieve this?
First, to ensure that the banks do not make bad loans, they are required to hold onto some of the loans and thereby share the risk with the Fed.
Second, as we discussed earlier, banks participating in the Main Street Lending Program will receive a uniform fee for their underwriting costs and a uniform interest rate to compensate for their cost of funds and the risk of default. These limits help avoid interest rates so high that they would deter participation from firms. But the flip side is that this may be viewed as too little for the banks, who may find this lending unprofitable (at least relative to other potential uses of funds): The risk of default is relatively high in the current circumstances, and the fee and interest rate might not be high enough to compensate for this. Moreover, in the event of default, the banks share risk equally with the Fed—they are “pari-passu” lenders—instead of the Fed bearing first losses. Additionally, there is no regulatory capital relief associated with the portion of loans that the banks must keep—they must be treated like regular commercial loans for risk capital purposes—and the tranches kept by the banks cannot be securitized. Overall, it seems plausible that some banks may elect not to participate, or may require significant collateral (which may be problematic, as we discuss next), or may only offer credit to their existing customers—in whose survival they have a direct financial interest (as we also discuss). Other issues, such as capacity constraints in underwriting and possible concerns about public relation implications (“headline risk”) may further reduce the banks’ incentives to participate.
- Firms may not be able to participate because of their current creditors.
For firms that already have outstanding debt, the new borrowing may clash with the terms of that debt—technically, may violate covenants on existing debt. The firms will then have to ask outstanding creditors for their permission to take on debt from the facilities. And hence, these actors must also have incentives to act and grant that permission. To understand this point, note that debt contracts often feature restrictions that limit overall borrowing, and/or that prevent the taking of additional debt, especially debt that is not junior to the existing debt or that pledges an asset as collateral (“negative pledge” covenant).14 It seems very likely that potential Main Street program loans will clash with some of these covenants. This is clearly the case for covenants that limit additional debt. But perhaps the issues of seniority and security are more important. The Main Street program loans, if they are unsecured, are required to be senior to (or on par with) existing debt. While this encourages banks to participate and protects the government’s funds, it also likely clashes with the covenants on existing senior debt. Relatedly, if program loans are secured by collateral used in existing loans, then the program states that they must be “pari-passu” in terms of security with these existing loans, which may clash with the negative pledge covenant.15 While covenants can generally be waived by existing creditors, their incentive to do so may be limited by the fact that the new program debt can generally not be used to pay down or roll over existing non-program debt.
Of course, a common case will be when the bank making the loan under the Main Street program is also the main or the sole outstanding creditor to the firm. In that case, the bank may be willing to participate in the new loan—even if unprofitable—because it increases the probability that the preexisting loans will be repaid. On the other hand, if the bank believes the company is likely to go bankrupt eventually, it has little reason to extend its borrower’s life.
Some firms, especially the riskiest ones, are excluded from the program
The program has been designed in a way that some firms are excluded altogether: Firms with more than 15,000 employees and $5 billion of revenue do not qualify for the Main Street program. (They may be able to quality for the Corporate Credit Facilities, but that requires that they were investment-grade rated on March 22, 2020, and have not been downgraded “too much” since then. This will exclude the riskier firms, especially private firms.)
Moreover, the Main Street program imposes limits on the size of the loans, as described in table 1. The minimum loan size may reflect fixed costs to underwriting loans, which make lending small amounts unprofitable; and the maximum loan size may reflect the banks’ (or the Fed’s) unwillingness to carry a large loan for one company. However, these loan size limits could constrain access to the program for either very small firms or firms with very large credit needs but no access to alternative sources of funding, such as the bond market.
Finally, the program also requires the firm to have overall debt below a certain multiple of EBITDA: less than 4 for the New Loan facility and less than 6 for the other two.16 These constraints protect the Fed against losses by excluding firms that are too risky and for which agency frictions (such as debt overhang and risk shifting) might be severe. However, they also effectively exclude the firms with the highest debt to EBITDA ratios, which are also the least likely to be able to obtain private funding.
There might be adverse consequences of the program in the medium run
Overall, it is plausible that the Main Street program will help support the short-run recovery, compared to a scenario in which the program was not implemented. After all, firms can always choose not to participate—so the program can do no harm to the firms.
It is conceivable, however, that in the medium run, after the immediate recovery from the pandemic, incremental debt incurred by firms via these lending facilities might slow the recovery. The principal mechanism is that borrowing from the facilities might marginally increase debt overhang. By debt overhang, we refer to various distortions that arise when a firm has “excessive” leverage: For instance, the firm may underinvest.17 As mentioned in our first post in this series, the corporate sector entered this recession with relatively high leverage, compared to historical norms. The Main Street program will add to this leverage by increasing the debt of participating firms. It is possible that the additional leverage will lead to increases in debt overhang with negative effects on the economy. For instance, investment rates could be persistently low after the crisis, relative to a counterfactual where fewer firms emerge from the crisis because of high liquidation rates, but are also, on average, less leveraged because they did not take on program debt. (To be sure, this is uncertain, because it depends on whether the labor and capital working for liquidated firms can be put back to work more quickly than if the firm continues with high leverage.)
An additional risk during the recovery is that the programs create so-called zombie firms. These are firms that are unable to return to profitability but are kept alive by the availability of loans. Some researchers have argued that the phenomenon of “zombie firms” was widespread in Japan in the 1990s and in Southern Europe in the 2010s. A similar phenomenon in the U.S. could harm the recovery by slowing the reallocation of capital and labor from unproductive sectors or firms to productive sectors or firms. In principle, the relatively short maturity of the loans reduce this risk—firms have to repay the principal within five years.
The Main Street Lending Program is designed to support the recovery by lending to businesses so they can ride out the pandemic and, hence, avoid inefficiencies associated with financial distress. Its potential size appears to be sufficient to meet the large borrowing needs of corporations in the months to come. However, there is significant uncertainty about take-up, because banks, borrowers, or existing creditors might be unwilling to participate. Moreover, some borrowers will not qualify. And finally, while the short-run effects of the program on economic activity are almost surely positive, the medium-run effects are more uncertain because higher debt might slow down the recovery.
1 We thank our colleagues, in particular Jonas Fisher, Leslie McGranahan, and Samuel Schulhofer-Wohl, for their comments on this blog.
2 In that post, we tried to quantify the magnitude of this illiquidity problem for publicly traded firms; our simple, and highly uncertain estimate is that perhaps 25%, sales-weighted, of public companies risked running out of cash by the end of the third quarter of 2020 without further borrowing (and without adjusting other margins such as investment or payouts).
3 Some of these actions are taken with the consent of the Secretary of the Treasury and with financial backing from the Treasury and Congress.
4 They are the Main Street New Loan Facility (MSNLF), the Main Street Expanded Loan Facility (MSELF), and the Main Street Priority Loan Facility (MSPLF).
5 The Federal Reserve has taken a number of other actions to support the flow of borrowing to corporations more broadly. First, the short-term commercial paper market and money market funds were disrupted in March. To address this, the Fed both purchased commercial paper directly through a new commercial paper facility (CPFF) and offered loans secured by assets sold by money market funds through the money market mutual fund lending facility (MMLF). The Fed is also creating a Term Asset-Backed Securities Loan Facility (TALF) that can provide financing against new issues of various asset-backed securities, including corporate loans that finance businesses. (The TALF will also support borrowing in many other sectors, such as auto or student loans, but our focus here is on businesses.) And finally, on top of all the facilities, the Fed and other banking supervisors have taken a number of supervisory actions to allow banks to increase lending, while maintaining safety and prudence standards. We do not discuss the paycheck protection program (PPP), created by Congress through the CARES Act and managed by the U.S. Small Business Administration, and the associated Fed facility (PPPLF), since they apply to small businesses and our focus here is on public corporations. We also do not cover the special measures affecting the air transportation sector under the CARES Act.
6 By law, the Federal Reserve Board must, after invoking its 13(3) lending authority under “unusual and exigent” circumstances, write a report to Congress that includes a justification. The reports are available here.
7 For instance, many companies have drawn down their credit lines as a matter of precaution, which reduces the ability of banks to lend further.
11 As a point of comparison, in July 2019, the Bank Prime Loan Rate—the rate usually charged by banks to their most creditworthy corporate borrowers—stood at 5.50%, or approximately 325 basis points above the three-month LIBOR. Thus, the financial terms offered to all firms via the program correspond, approximately, to terms normally available only to the most creditworthy of them.
12 These compensation limits are described in section 4004 of the CARES Act, which is available here. They primarily affect employees and officers of the firm that received high compensation (i.e., in excess of $425,000 per year) in 2019.
13 Technically, at the expense of the SPV funded by the Fed and Treasury, but we will refer to this as the Fed facility for short.
14 Covenants restricting firms’ ability to take on new debt, or restricting new liens on the firm’s assets, are common, particularly in loan contracts of medium-sized and large firms. For instance, this recent working paper studies a sample of 1857 credit facilities in the leveraged loan market and finds that 92% of them have restrictions on new liens and 87% on incurring additional debt. This paper studies a sample of 3,603 private credit agreements (loans) of public firms and finds that 97% of them contain covenants, 90% of which imply an effective restriction on borrowers’ total debt. By contrast, in a sample of bond issues, this paper shows that only 22.4% of issues in the 2000–03 period contain restrictions on total leverage, while only 42.5% contain restrictions on issuance of secured debt.
15 One exception is that loans made through the Main Street New Loan Facility, if they are secured, can be secured using second liens, as stated in section B.3 of this document. In that case, the secured lenders may accept that the collateral is pledged as second lien, since they retain priority, but the security provided to the new lender is of course significantly less, which may reduce the willingness to lend.
16 For these purposes, EBITDA can be calculated with the standard adjustments.
17 The classic debt overhang mechanism is that shareholders/managers may not take advantage of profitable investment opportunities if leverage is too high, because the benefits of investment, if successful, are more likely to accrue to debtholders. More generally, firms with high leverage may face high costs for external finance, which in turn reduces their incentive to take on new investment projects.