4.0 Covid19 Risk Strategy — Policy response — Is it big enough yet?

March 22, 2020

Viju Joseph

Covid Economic PopUp Research and Portfolio Advice

THE BACKGROUND

There are a large set of fiscal policy proposals in discussion and the corporate rush for bailouts is intense. In this series, I present a series of proposals that need to be enacted to limit the downside damage of the Economic outage. I must clarify that I am not a supporter of bailouts , but the proposal below emphasizes financing packages at fair market values and waiver of debt for small businesses in distress. The magnitude of the crisis requires a response proportional to the shock, in order to avoid further economic contagion. In this article, I delve deeper into the policy toolboxes for each of the dislocations.

1. Significant employment losses
2. Interest and Cash Flow management for Consumers and Businesses
3. Financial Package for Systemically Important Infrastructure.
4. Financial Package for Banking Institutions
5. Tax Policy & Market Closure policy

A high level summary of my proposals are (Note 3 months is placeholder, could be extended if needed)

1. Get cash flow at consumers and corporates stabilized, by providing liquidity and extending terms of debt by extending terms by 3 months, and making no interest payments for the next 3 months (a cash flow neutral, pay it forward structure).
2. Provide financing packages for systemically important infrastructure corporates / banks at fair market values in order to stabilize the sectors. Use the AIG bailout as the model.
3. Ensure that small business loans are duly forgiven, so small businesses that have lost money can survive. Avoid personal collateral to minimize damage to the sector.
4. Manage tax policy to aid in the above and Keep markets open to receive real time information on the changes.

Previous Links in the series.

1.0 Risk in the Time of Covid March 6

2.0 Ground Zero of the Economic Downturn March 10

3.0 The myth of well capitalized banks March 15

THE KEY CHANGES SINCE 3/10: The initial response is encouraging, and bipartisan moves excellent. At a high level, thedirection is right and but the sizes will be extended.

1. Shutdowns/ Lockdowns — 2 week shutdowns will extend by 2–3 month.
2. Fiscal policy response — $1T policy response will extend to $5T or more over time.
3. Monetary policy response — mostly done, and in the objective of stabilizing market dislocations.

THE KEY ECONOMIC POLICY PROPOSALS

Effective April 1, 2020, Federal and State governments should jointly agree to a policy that encompasses all of the above

POLICY PROPOSAL 1.

UNEMPLOYMENT MANAGEMENT POLICY

I expect 10mm+ claims over the next 2–4 weeks, peaking at 25mm unemployed by May/June.

1. Provide zero waiting period and zero denial of claims (proving previous work history etc)
2. Extend from 13 weeks to 52 weeks.
3. Automatic extension of health insurance for while on unemployment with zero COBRA payments for 3 months (any costs related to this can be deducted on Insurance company taxes/ bailouts if needed on realized losses for these)

COST: $400- 500B

POLICY PROPOSAL 2.

LIQUIDITY POLICY FOR CONSUMERS AND CORPORATES:

A massive liquidity drive needs to be provided to all consumers and corporates, by zeroing out all payments from consumers and corporates to investors. It’s a 3 month interest and wealth transfer, with extension of all debt, foreclosures, and similar agreements.

INTEREST/DEBT Extension:

1. All interest is zero (0%) for the next 3 months, Treasuries, banks, credit, loans, credit cards, private lending (irrespective of term or maturity), issued by a bank or corporate or in private markets.
2. Extend maturities on all mortgages, bonds, debt instruments and public/private lending contracts by 3 months. (defers the interest to the maturity end)
3. All borrowers can elect not to pay any interest or principal on any debt for the next 3 months (if you pay it only reduces your principal balance)

CREDIT / DEFAULT prevented

1. Institutions are not allowed to enter into forecelosure/ non repayment proceedings, repossession of homes or businesses for failure to pay on debt by either consumers or corporates.
2. Any credit card payments, loan payments, car lease payments, are zero for the next three months. All terms of loans, and related covenant/ forbearance agreements are extended by three months. Terms of all leases/ loans are extended by three months.
3. No adverse reporting on Credit Scores/ Business impact for the next three months.

RENTS capped:

1. The first $2000 (TBD) of any rent payments by consumers for home rentals are not to be paid. Any amount above that number must still be paid.
2. The first $5000 of business property rent is not to be paid if your annual revenues are less than say $5mm USD.

DERIVATIVES CASE BY CASE (There are more complications here which must be addressed)

1. All credit market derivatives must replicate the interest and maturity rules of the underlying bonds.
2. All Interest rate and FX market derivatives are unaffected. Derivatives will not have their maturities extended by government mandate, but can be done so by private decision making.
3. All commodity contracts are unaffected. All equity linked and commodity linked structures, are unaffected other than any interest rate linked component.

LIQUIDITY IMPACT: Consumers small businesses get a debt/ liquidity breather. Landlords with mortgages receive the same. End wealth owners, receive lower returns, offset some by tax policy.

COLLATERAL IMPACT:

• Support the US pension funds by providing a cash infusion for any fund with less than 105% funded ratio, who are US domiciled by providing an amount of infusion equal to the loss of interest income.
• Banks and Insurance Companies will experience a loss of interest for the 3 months, but subsequent earnings as the maturity of the debt is extended.
• This is a temporary wealth transfer from lenders to borrowers.

COST: $200–400B (difficult to estimate without a detailed analysis. The Government doesn’t pay interest on Treasuries which would offset some of the infusions needed.

POLICY PROPOSAL 3.

FINANCING PACKAGE (BAILOUT) POLICY FOR NON BANKING PUBLIC INDUSTRIES

The government needs to classify certain industries as Systemically Important Infrastructure Industries (SII) this includes Transportation, Defense, Energy, Healthcare, and Food Supply Chains (maybe others, but exclude Hotels, Entertainment, Cruise Ships and discretionary consumption firms). For the SII, there will be loans made available as per the following

1. The loans should be junior to existing debt holders, but senior to equity
2. The interest rate on the loans are PIK (accrue till paid off at 5–8% interest)
3. The government should receive equity warrants in the company with a notional of 50% (TBD) of the loan amount, with a strike price at 110% above the last 10 trading close days as of the day of program announcement
4. All SII public companies can obtain this loan, in size, and must decide within 5 business days of the announcement.
5. All SII private industries, will have the same structure, with strike price determined based on a full valuation at the lower of (50% of Dec 31, 2019 valuations, valuation as of March 31, 2019)
6. There will be no dividend payments or stock buybacks or bonuses for management until the government loans are paid back.
7. The exact mechanism of distribution of these loans, will need to be worked out.

For Systemically Non-important sectors like Hotels, Tourism, Cruise lines, Amusement parks that are not small businesses, there will be an ownership transfer from equity holders to debt holders and restructurings as needed. I’m not in favor of any government sponsored financing packages for them.

IMPACT: Businesses will need to ascertain the trade off between a bailout, and dilution of equity/ option. There is a fair price for bailouts, and businesses would have to earn them.

COST: $0. Cash Flow: $200B. If done at a fair price, the government recovers all its money back and receives an equity payout.

POLICY PROPOSAL 4.

FINANCING PACKAGE (BAILOUT) POLICY FOR BANKING AND SMALL BUSINESS LOANS:

As per my previous article the banking industry will suffer major losses due to the upcoming recession, driven by small business loans. In order to minimize the impact of this to both small businesses and the banking sector, the government needs to have a two pronged approach — Modify the SBA programs directly and provide Financing packages for the banks at Fair Market values.

SBA Government Guaranteed Loans — approx $500B outstanding, $150B in losses expected

1. Government should increase the guarantees of SBA loans from 75–85% guarantees to 100% guaranteed
2. The interest rate on these loans should be reduced by 400 bps in exchange for this guarantee.
3. All loans should exclude personal collateral and guarantees (only business collateral is allowed), permanently, so knock on effects onto personal collateral is minimized if a business is liquidated.
4. Any loans in default, forbearance or foreclosure, or entering in the above in the next six months, should be waived in full, if the underlying business shows losses for both 2019 and 2020 combined basis on their tax returns after excluding payments to principal owners. These are businesses that cannot recover.
5. No adverse credit reporting, due to Business failures. We need to encourage these businesses to startup again in different formats.
6. Exclude businesses, with less than 65% equity ownership from Founders/ Principals (TBD exact number)
7. Provide options for recapitalization/ and sale as is, with bank backing, instead of shutdown.

IMPACT: Minimizes the amount of collateral that comes to the market, and mass defaults of businesses. It further protects small business owners from collateral liquidation of their personal properties, and spillover into the residential mortage and stock markets.

Banks and Financial Institutions: “Financing Package”

1. Governments will guarantee the first 20% losses on any non SBA guaranteed loan books for Small/ Medium Enterprises and 10% of losses on large commercial enterprise loans.
2. As part of this guarantee, the government will invest in preferred stock of the bank which would lose value against loan losses. The government will also buy equity or equity warrants in the bank upto 50% of the amount of the preferred stock investment, on same terms as for the SII’s in Policy Proposal 3.
3. Any firm doing this must provide a 25% loan size increase option for any business, subject to the same SBA / commercial lending terms, as part of the bailout, but included in the same first loss guarantees. Lending terms at banks that take the financing package out are at the same lower rates for SBA loans.
4. The banks will be prevented from further buybacks or dividends, till the preferreds are paid back or lose value.
5. The government can auction the equity/ warrants after 12–24 months to monetize the bailouts.
6. Regulators can assess which banks will need to take a capital infusion versus which banks can elect to, based on their liquidity situation.
7. While the preferred debt exists, debt holders will receive only 50% of the coupon interest on the bonds. The remaining 50% will go to pay the preferreds down and PIK for the debt holders.

IMPACT:

1. There is a price for a bailout. It should apply equally to all institutions
2. The equity holders and debt holders must share in the cost of doing

COST: $200–400B (Government suffers loan losses on SBA loans and bank loan book guarantees, but makes money on equity)

POLICY PROPOSAL 5.

NON CLOSURE OF FINANCIAL MARKETS: Markets are the best collective information source if things are working or getting better. Shutting them down, will have negative consequences to the path forward.

1. Markets need to be open for business to see the translation of policy to financial conditions. Markets are the best real time information of what is happening and shutting them down provides unnecessary pressures on liquidity and cash flows.
2. If a closure is deemed necessary, we need a 30 day notice and a predefined closure period — The government must provide a minimum 30 day notice period for closure of financial markets. All derivative markets need to come up with a policy on how a term closure will be handled.

It is important to clarify this policy to avoid any panic runs in the market.

POLICY PROPOSAL 6.

TAX POLICY

1. All National and state/local tax filings, can be elected to be on 1 year basis or consolidated 2 year basis, to be filed by April 15, 2021 for both individuals and corporations with less than $50mm annual revenue.
2. No penalties or interest accrue on past Tax receivables till April 15, 2021
3. All Property tax payments are postponed by three months from their collection dates, with no penalties or interest
4. Any amounts of interest owed but not received can be deducted as a special Expense in tax returns both by individuals and corporates, with no AMT limits.

COST: None — just timing of cash flows.

IMPACT: Enables business to better plan their cashflows through a large swing in the economic cycle.

EXECUTION FRAMEWORK

HOW SHOULD THE GOVERNMENT DO THIS?

1. $2T of debt must be issued/ immediately monetized by the Fed as QE. Across maturities (1–5 year sector). The amount can be increased over time as needed.
2. Have a single comprehensive announcement across all policy measures as passed by Congress.
3. Loan and financing package applications must be swift and decided by corporates and small businesses within 5 business days and submitted.
4. Public website dissemination of all approved bailouts > $10mm to public and private institutions alongside terms and conditions.

WILL THE GOVERNMENT DO THIS:

YES ; But only after the Equity Markets fall To 50% of All Time Highs.

About the Author:

I have about 20 years experience in C-level and Senior risk positions at banks and large hedge funds. All of the views are mine, and all the errors and inaccuracies are mine too. I believe this will be the largest market disruption since the Financial Crisis of 2008, and will have a comparable impact to the global economy and financial markets.

I can be reached for discussion and professional enquiries at

Linkedin: https://www.linkedin.com/in/viju-joseph-4436243/

Email: viju0812@gmail.com