In the coming weeks, American small, medium and large businesses will report the devastating top-line financial consequences caused by the COVID-19 induced cessation of global GDP. And, the first week of April will be America’s first payment cycle since the implementation of our ambitious Health response and the first time the vast majority of interest, rental, and other payment obligations will be unmet by Americans and American businesses alike.
America is the greatest and most compassionate country in the world and, our government representatives from the President, to Congress, to our state governors are doing a tremendous job in creating a unified response against the COVID-19 virus, while contemporaneously attempting to alleviate the economic pain that accompanies it. The following is an attempt to supply a few readily available tools to make the remedial impact of CARES reach even deeper to the owners and renters of small and medium sized businesses in providing temporary relief to their mortgages and corresponding rents.
There is a credit problem: businesses need money because you and I are not spending. Businesses have no revenue; their workers, landlords, and trade creditors want to be paid.
The roles of the Treasury Department and Federal Reserve are different in a recovery. The Treasury Department is part of the Executive Branch. It receives its funding from taxpayers. It is accountable to Congress and to the President. It just received $454 billion in the CARES Act. The Federal Reserve, in contrast, is an independent, quasi-governmental agency. Its members are banking institutions who keep massive reserves on deposit at the Fed. The Federal Reserve has many roles in the economy, but none of them is to take on credit risk. So how do you get the Fed to establish a “loan” facility, as contemplated in the CARES Act, if it will not take on credit risk?
Here’s how: The Federal Reserve will insist that Treasury contribute money from its new pot of $454 billion to a joint Fed-Treasury lending fund. The Treasury’s contribution you can think of as “equity” — that is, Treasury will stand in a “first loss” position on every loan made to corporate America. The Fed will contribute the “leverage” — the money that will help make loans but which is never put at actual risk. The loan fund will then make loans to businesses.
The overall size of the Fed-Treasury loan fund depends on how much risk-averse Fed money will be supplied for every dollar Treasury contributes. The answer is almost exclusively a function of what is called the “credit box.” If the loan program makes loans only to investment grade companies (those rated BBB or higher), the Fed will contribute more capital than if the loan program makes loans to companies with lower credit ratings or no ratings at all. In other existing Fed loan programs, the Fed supplies about $9 for every $1 of Treasury capital, but in those programs the loans are secured by extremely high-quality collateral (often AAA).
But here’s the thing: most investment grade companies don’t really need government loans at the moment. If they need capital, they can issue corporate bonds and still, today, get decent pricing. We need to give a road map of relief and access to the small and medium sized enterprise.
The companies that really need credit — those that don’t issue bonds and can’t get credit from their bank loans — are not investment grade — mostly the small and medium sized businesses. These mid-sized and smaller companies are the ones desperately in need of financing to maintain payrolls and preserve their ongoing, if skeletal, operations.
But lurking in the background is a financial markets liquidity crisis, already teeming in some corners. Liquidity is how easily a business can convert a thing of value into cash. A liquidity problem is when that conversion process encounters friction. Do not confuse this with a credit problem, which is where you don’t have the thing-of-value (e.g. a revenue stream) and you need to borrow money to bridge between revenue and payment obligations.
Since the Great Financial Crisis, our economy has experienced the profound benefits of a significant inflow of non-bank capital. This non-bank capital is critical to the support of consumer lending (installment, credit card, student, and auto loans), business lending, and real estate financing (i.e., commercial real estate (CRE) not guaranteed by Fannie and Freddie). Put aside arguments about regulatory adequacy for a moment: this capital formation is a good thing. A greater supply of secondary market capital increases the availability of efficiently priced credit for those who need or want it in our society.
When a company makes a 60-month auto loan to a consumer, the lender will receive monthly payments for the next 5 years. Now the lender could wait that out, in which case the lender would not have cash to make a loan to the next borrower, or the lender could sell off the right to receive payment on that loan for a value that equals the payments discounted to present value. The latter is what happens. The lender either directly or indirectly bundles, or securitizes, the book of loans and sells different slices of the overall revenue stream from the bundled loans. These slices are called ABS — asset- backed securities — because they are securities that are backed by assets (which are the loan revenue streams). This happens with auto loans, student loans, credit card books, CRE loans, etc. Main Street lenders get cash and investors in these securities take on the bundled risk according to their respective risk appetite and investment objectives.
Investors in these ABS are insurance companies, banks, asset managers, pension funds, and other large institutional investors. Their investments — especially investments by regulated entities like insurance companies — are in the investment grade tranches of these ABS (BBB and higher). These investments produce a return that helps the insurance company have enough money to pay out claims or helps the pension fund have enough money to pay retirees.
How do investors in ABS get the money to buy the ABS? Often by entering into liquidity transactions called repurchase agreements (or “repos”) with banks, who advance the cash to the investors and hold the ABS as collateral. The investor promises to repay the repo loan upon maturity (technically this is a sale-and-repurchase but it is viewed as a loan), which is usually short term (but is often rolled over into a new repo loan).
Enough background, here is the problem: the repo agreement states that if the collateral value (i.e. the value of the ABS) begins to plummet, the borrower must make a margin call, i.e. must put up cash to ensure the bank lender has adequate protection. If the borrower cannot or does not put up margin, the bank sells the collateral, which, obviously, has a lower valuation. An accounting rule required by the Dodd-Frank Act requires “mark to market” or “fair value” accounting, meaning the value of the collateral must be determined by the value it has in the market.
Imagine what happens to the value of ABS collateral (including commercial mortgage-backed securities, or CMBS) when: (i) students stop paying back loans; (ii) consumers stop paying down credit card or installment debt; (iii) mall tenants stop paying rent; (iv) nobody is paying to stay in hotels; etc. Two things happen: one, the ABS loses actual value (but on a big scale, not much value as it is only one month of payment missed); but two, and much bigger, nobody wants to buy those securities when the underlying contracts are not performing. The market asks “who knows how long people will continue to not pay?” Values plummet, not because the underlying assets are not healthy (they are) but because there is a complete loss of confidence in these securities by the market. Plummeting ABS values means plummeting repo collateral values, which means margin calls and repo foreclosures.
Call to Action: Federal Reserve Collateral Expansion and Regulatory Relief on Forbearances
Trillions of dollars are invested in this collateral. Huge ramifications if it suddenly gets flushed at fire-sale prices. What is desperately needed is two actions: (i) for the Fed to step in and create a market for investment grade ABS and CMBS at pre-COVID advance rates to restore confidence and pricing in the market; and (ii) a margin call holiday or forbearance period (described below).
America needs the immediate cooperation and support from our banking sector from JP Morgan to Wells Fargo, who need corresponding regulatory relief, in order to successfully combat COVID-19.
As a result of our collective fight against COVID-19, American businesses are unable to generate revenues from the ordinary course; consequently, America’s businesses are unable to make lease payments on the office, retail, and industrial buildings which they occupy. And, if owners of buildings are unable to collect lease payments, these real estate owners will inevitably be unable to meet their interest and debt obligations to their lenders. Just as our great federal housing agencies have rightly granted forbearances to owners of multifamily properties who, in exchange, themselves extended forbearances to their underlying tenants (many of whom are unemployed as a result of the fight against COVID-19), commercial landlords and lenders need to do the same.
What happens when nobody makes payment on anything? Every loan in America is in danger of going into default.
In order for lenders to grant American businesses a “time-out” by forbearing rent payments, they need to be able to get forbearances from their lenders, the banks and other forms of credit such as commercial mortgage backed securities. Furthermore, these banks need to grant real estate lenders in the non-bank sector a “mortarium” on repo margin calls.
The only way to accomplish this relief to American enterprise is by receiving forbearances on the interest obligations that real estate owners and mortgage real estate investment trusts owe to the banks and their other security lenders.
Call to Action for Regulatory Streamlining
- Regulatory relief for banks from the “fair value” requirements under the capital rules and the consequence of Mark to Market when there actually is no market.
- Federal Reserve support (via SPV) to purchase non-agency CMBS in order to set a floor to the entire debt stack and stabilize values across securitized and non-securitized debt and equity markets. These SPVs could be capitalized by US Treasury or private capital.
- Federal Reserve support (via SPV) to purchase repos themselves. SPV capitalized by US Treasury or private capital.
- Other structures involving private capital that is supported by Federal Reserve financing including warrant or equity participation in return for advances or loans across CLO’s, REPO lines or other structured financing vehicles.
- Suspension of CECL and the relaxation of LCR where appropriate.
All of the above is simply a menu of concepts and ideas for discussion amongst industry regulators, and other stakeholders. These are my personal statements and not necessarily reflective of the companies in which I am a participant.