Fed prepares nuclear bomb for COVID-19 fight

This morning, the U.S. Federal Reserve announced an unprecedented program even by the standards of the 2008 financial crisis. For the first time in its history, the central bank is lending directly to the real economy, including municipalities and non-investment grade companies.ⁱ The Fed is using CLO technologyⁱⁱ  and a 5% shared loss from banks to leverage only $190MM of CARES Act discretionary funds into this unprecedented $2.3 trillion total program size.
 
Perhaps most remarkably, this implies that the Fed has a comparable amount of dry powder left for additional programs or an expansion of these. The CARES Act allocated $500 billion of fiscal stimulus to Treasury for it to deploy on a discretionary basis. That leaves another $310 million of capital to create another $2.5 trillionⁱⁱⁱ or so of additional funding for this or other programs. Fed Chairman Powell said this morning that the Fed’s ability to continue providing liquidity “is really unlimited” and that inflation “is not a concern at this moment.”
 
Banks are working overtime on numerous initiatives to carry us through this crisis. Community banks were singled out by Secretary Mnuchin this morning as being particularly vital to the economy. However, these institutions face unique challenges, which include:

1. Assisting existing clients through all the new programs being launched in rapid succession
2. Re-underwrite the credit quality of all loans in light of the extraordinary economic shock offset by the unprecedented federal support
3. Incorporate all these moving variables into revised expected loss models for capital calculations, including CECL reporting for GAAP reports

 
Summary of a Nuclear Bomb
 
Today’s announcement has four primary components:

1. Main Street Lending Program (MSLP). A $600 billion program to provide loans directly to businesses with less than 10,000 employees and less than $2.5 billion in revenues. This program will be backed by a $75 billion first loss provision from Treasury as provided by the CARES Act. Importantly, these loans can be made in addition to loans under the previous Paycheck Protection Program (PPP) to the same obligor.
2. Paycheck Program Liquidity Facility (PPLF). Supplies 100% liquidity to banks and other financial institutions against loans made under the prior PPP. This program size is unlimited.
3. Municipal Liquidity Facility (MLF). A $500 billion program for lending directly to municipalities including U.S. states, the District of Columbia, U.S. counties with at least 2 million residents and U.S. cities with at least 1 million residents. This program will be backed by $35 billion of first loss protection from Treasury as provided by the CARES Act.
4. Term Asset Liquidity Facility Expansion (TALF). Assets eligible for collateralized loans at the NY Fed will now include AAA rated tranches of both collateralized loan obligations (CLOs) and commercial mortgage backed securities (CMBS). This component is particularly extraordinary given the taint structured products like these received during the financial crises.

 
Intent
 
The stated objective of today’s action is to “provide powerful support for the flow of credit in the economy… during this period of constrained economic activity… helping ensure that the eventual recovery is as vigorous as possible.” The clear messaging here is that the Fed is not done and that the size and scope of these programs is likely to increase.
 

Triage Time for Lenders
 
In the midst of new working conditions caused by this pandemic, banks and other lenders must manage multiple needs in a prioritized waterfall approach. Communicating with borrowers at this time is critical.
 

• Lending officers will need to:
  • Understand and communicate the massive new programs available to their clients, not only for the benefit of their clients, but also to preserve the credit standing of their loans
  • Understand and communicate through credit channels the particular economic challenges facing their clients and how those clients are addressing the challenges
• Credit Officer will need to:
  • Re-underwrite virtually all loans and borrower ratings based on the particular and offsetting impact of forces on individual borrowers
• Chief Financial Officers will need to:
  • Adjust capital and leverage ratio forecasts based on revised portfolio adjustments
  • Adjust CECL forecasts, models and assumptions
• Treasurers will need to:
  • Adjust funding and liquidity projections based on these new liquidity programs which may offset new funding requirements such as draws on committed lines and PPP loans

 
Moving Forward
 
Lending franchises will be made and lost during this crisis. In particular, this is a time for community banks with deep client relationships, empowered by the right technology platforms, to take advantage of government programs designed to keep their clients in business. Banks that fail to help their clients through this process because they cannot adequately track the moving credit or capital impact will surely be remembered by their market when this pandemic storm passes.

Source: U.S. Federal Reserve, April 9, 2020.
https://www.federalreserve.gov/newsevents/pressreleases/monetary20200409a.htm

_{ⁱ  In normal practice, the Fed lends only to depository member banks. In 2008 it took the unprecedented step of lending to AIG, but that was a one-time, highly structured and highly collateralized loan supported by a special Act of Congress with TARP. Other notable loans to Goldman Sachs and Morgan Stanley were not consummated until those institutions changed their charters in a weekend. Support to Bear Stearns was made through JP Morgan at the time. The innovative structure announced today represents the first time in Fed history that they will be lending directly to non-depositories.}

_{ⁱⁱ  The Congressionally approved funds from the CARES Act are being deployed as first loss capital into a series if special purpose vehicles (SPVs). The Federal Reserve will fund loans made by these SPVs. Since the loans will be structured to be diversified by industry, geography and obligor, the Fed can meet its legislative mandate of zero loss underwriting on the portfolios given the capital support provided by Treasury.}

_{ⁱⁱⁱ  Assuming a leverage ratio of about 8x.}