If you happen to know how long the COVID-19 pandemic will last, you can figure out what emergency measures the economy is ultimately going to require and when. If it continues, the government must expect that the pandemic will drop two shoes — a liquidity crisis and then a solvency crisis.
The first threat to the economy – a systemic liquidity crisis – is being addressed by lending and asset-purchase facilities launched by the Federal Reserve and Treasury that are attempting to flood the markets with loans and grants. They are doing a great job with the authority that Congress has given them. And, given the broad outcry of complaints to date by hopeful participants, these programs either have been effectively calibrated or unnecessarily littered with conditions that make them unattractive or unreachable. In any event, such liquidity elixirs can only work for so long before a shortage of cash or a cascade of losses turns into an equity crisis that begins to take down companies as well as their banks.
History is littered with examples of this death spiral. If the pandemic shutdown of the economy lasts, even companies that can pay their bills eventually will start to lose money as those losses eat away at the net worth of the company. It’s simple math: If a company has $100 of shareholder equity and it experiences a net loss of $50, it will have $50 of shareholder equity left. If that trend continues, the company will have to raise new capital or find a merger partner, both of which are highly unlikely in this situation. The only other alternative is filing for bankruptcy protection, which is a catastrophe when thousands of companies are doing it all at the same time.
The government will have to develop a new form of capital assistance such as the Troubled Asset Relief Program (TARP) of the 2008-2009 recession – perhaps a Pandemic Revitalization Finance Corporation, patterned after the Reconstruction Finance Corporation of 1932 – to keep companies in business. Purchasing equity securities from them, such as the senior preferred stock that the Treasury still holds in Fannie Mae and Freddie Mac, will underwrite the economy and may even earn the taxpayer a profit.
It is only a matter of time before today’s liquidity problems at hotels, airlines, restaurants, retail stores and agricultural companies become financial losses that increased borrowing cannot solve. That fuse already has been lit. The U.S. economy has a self-protecting set of trip wires that are largely self-executing but quite difficult to shut off when times turn bad. They are intended in normal times to prevent failing companies from prejudicing the interests of investors, creditors, depositors and competitors. In difficult times, however, they can exacerbate the situation.
For example, generally accepted accounting principles drive what the financial statements of every public company must reveal and when. If losses eventually force a public company to report something approaching zero net worth – no shareholder equity – a legal doctrine known as the trust fund theory shifts the board of directors’ fiduciary responsibility and focus from the shareholders to the creditors as the principal parties in interest. That changes how and why the company and its board of directors must act. In short, the company must begin to act as if it is going out of business.
When that happens and shareholder equity shrinks toward zero, companies begin to run into a host of challenges. Default provisions in contracts will likely be triggered, lenders will call in lines of credit, and counterparties will have exercised extraordinary relief permitted in such circumstances. This creates a self-fulfilling spiral of financial distress. In effect, others may stop doing business with the company as they learn the bad news so that they are not prejudiced when and if disaster explodes. Companies must disclose their financial status – whether good, bad or disastrous – and, as they do, there are legal accounting, operational and banking results that follow.
The banks are the next stopgap in this crisis. The government has been more prepared for the Financial Pandemic of 2020, having exited from the last crisis just a decade ago. The Dodd-Frank Act strengthened U.S. banks and the economy for this crisis by increasing bank capital and liquidity, but that capital will decrease as the economy continues to get pounded. That is, after all, what it was for. Dodd-Frank bought the banks additional months of oxygen before they too started choking, but it did not make them invincible.
Congress and the bank regulators have stepped in to lessen the accounting losses that banks and other lenders have to recognize, by affording them flexibility in when to classify them as troubled and how to estimate the losses that must be booked. That will not help commercial and industrial organizations, and it will only soften the blow for lenders for so long. As borrowers continue to deteriorate, loan repayments will stop, and no amount of relief from accounting principles will, ultimately, save a bank from eventually having to write off loans that aren’t being paid. In this crisis, the government will try to stop that deterioration from reaching the banks — but if the virus persists, the only sure way of doing that is through the purchase of equity from troubled companies or the banks themselves.
Congress and the regulators may hope that only one shoe will fall, but they should be getting ready to deal with the second one.
Thomas P. Vartanian is executive director and professor of law of the Antonin Scalia Law School’s Program on Financial Regulation and Technology at George Mason University. He is a former bank regulator and has counseled many financial companies and investors.