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Fed: Lender of all Sorts

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“Broadly, people are undertaking these sacrifices for the common good. We need to make them whole, to the extent we have the ability to make them whole, we should be doing that as a society. They didn’t cause this. Their business isn’t closed because of anything they did wrong. They didn’t lose their job because of anything they did wrong. This is what the great fiscal power of the United States is for, is to protect these people as best we can from the hardships they’re facing.”

- Chairman Powell, April 9, 2020


The Federal Reserve Chairman Jay Powell went even further today to leverage the $2.2 trillion CARES Act and increase the availability of credit to households, firms, institutions and state and local governments. The goal is clear: The Fed wants to do all in its power - which is limited to lending not spending - to ensure as many as possible can bridge COVID-tainted waters without slipping in. Chairman Powell sees this as a health crisis, which is unique from any other disruption, and intends to do all he can to stop the crisis from metastasizing into a larger economic crisis. Powell and other Fed officials cannot stop the recession but they can help to keep the economy afloat until it can gain traction and respond to stimulus on the other side of the crisis. That is where the Fed has the most power - to stimulate and add fuel to a recovery.

Moral hazard is not part of the debate as it was within the Fed during the financial crisis in 2008-09. That is because this time really is different. We have to abandon our biases and warehouse them to deal with a health crisis. It is not the time to discuss who is worthy of our efforts.

More for Longer

Today, the Fed pledged an additional $2.3 trillion in lending facilities. This is in addition to a dozen interventions to support a broad array of lending since March 3. The new lending facilities allow the Fed to expand its lending to households, firms of all sizes and state and local governments “that were in good financial standing before the crisis.” The change in the verbiage to include the status of borrowers prior to the crisis is crucial, as borrowers have suffered widespread downgrades to their credit ratings in response to the crisis alone.

The breakdown of the new program includes:

  • An expansion of existing facilities of $100 billion to purchases of highly rated tranches of existing and new commercial mortgage-backed securities. This is in addition to purchases of asset-backed securities to fund student loans, auto loans and credit cards. The goal is to strongly encourage banks to lend aggressively. The work to shore up bank balance sheets in the wake of the 2008-09 crisis worked; banks are able to do this today.
  • Purchases of $750 billion in corporate debt that had investment grade ratings as of March 22, 2020. This allows “fallen angels’’ - firms that were investment grade prior to the crisis and later downgraded - to get access to the liquidity they need to stay afloat. This allows large traditional retailers such as Macy’s, J.C. Penney and Gap to qualify.
  • Purchases of $349 billion in small business loans guaranteed by the Small Business Administration to become grants if firms rehire/maintain payrolls through September 30. This will expedite what has been a rocky rollout of the program, as it alleviates the risk to banks, which is the intent of the legislation. (The entire system was overwhelmed.) The administration is currently seeking an additional $250 billion for small businesses, given the extraordinary demand for such loans/grants. Powell endorsed that move and stands ready for the Fed to do more to expedite those loans.
  • $600 billion in loans to midsize or small firms with less than 10,000 employees and revenues less than $2.5 billion. Loans will be four years in duration and range from $1 million to $150 million for companies registered in the U.S. Principal and interest will be deferred for a year. This is an attempt to stem what could otherwise be an unprecedented surge in bankruptcies. Some firms will qualify for both the SBA - backed loans and this program. Both incent borrowers to maintain payrolls, but SBA loans can be forgiven.
  • $500 billion in loans to states (including D.C.), counties and cities. This is to help states and localities to bridge the gap in funding due to tax revenue deferrals. It does not alleviate the need for direct transfers to the states, as they are limited in what they can finance via debt. The hole in state and local budgets looks to be about $400 billion. Illinois alone has a hole twice what it endured in the wake of the 2008-09 crisis. If those holes are not filled with transfers to the states, we will see draconian cuts in state and local budgets, hitting essential services at the very moment we are attempting to reopen and ramp up the economy. This was a mistake made in the wake of the 2008-09 crisis and cannot be repeated today. Powell also agreed that the states need to see transfers from Washington to fund their shortfalls in revenues.

    What is extraordinary about this announcement is that it was accompanied by a promise from Powell to do more for as long as is necessary. He made clear that the Fed would be slow to remove the support and will do all that it can to stimulate the economy on the other side of the crisis.

    Powell noted other areas the Fed is watching, including the mortgage market. Mortgage servicers have taken it on the chin as they must make good on payments to investors, despite payment holidays of 6 months to a year on home mortgages. We plug one hole, only to open another. The Fed is focused on keeping the mortgage market functioning so that housing can do what it did not do the last time around, and that is to lead us out of recession. The reasons that employment was so subdued coming out of the Great Recession were: 1) sharp cuts to state and local government spending (mostly teachers), and 2) persistent collapse in the housing market - the most interest rate-sensitive sector in the economy was still on its back.

    Today’s Fed actions come on the heels of a slew of staggeringly bad reports on the economy. Initial unemployment claims came in at 6.6 million the week ending April 4. That brings the number of those who successfully filed for unemployment insurance to 17 million, which is an understatement of the actual number unemployed. State phone lines and websites seized under the weight of the sheer volume of applications. Many states have been unable to adjust the application process to include the workers added by the CARES Act: furloughed workers, gig workers, contract and self-employed. This means that we have already likely doubled the loss in employment during the Great Recession, which was 8.8 million, in the course of four weeks. Some of those who were fired could be rehired with the loans/grants to small businesses. Owners have to keep the workers on payroll through September to qualify for the loans to become grants. We will likely see another round of layoffs in the fourth quarter as many of those workers still may not be needed.

    If the participation rate were to hold, the unemployment rate would already be in the 15% range. It could go to 20% by the April survey, which will be taken the week of April 12. We have already seen a precipitous drop in participation. Women have been especially hard hit as they are more likely than men to care for the sick or children home from school. It is also hard to say you are actively looking for a job when much of the economy is literally shut down.

    Separately, consumer sentiment plummeted in early April at its fastest pace on record. Current economic conditions were hit harder than expectations for the future, which suffered a large blow last month.

Bottom Line
The economy is deteriorating rapidly with no one to blame. The Fed will do all it can to stem the hemorrhaging but it is still limited. It can lend but not spend. The latter is the purview of Congress; it will need to do more to aid individuals, businesses and state and local governments, provide protocols and funding to safely reopen and stimulate when the economy is in a position to respond to those measures. It will be a long Spring.

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