The good news from Washington is that despite partisan divides, Congress and President Donald Trump moved swiftly to enact the CARES Act in response to the COVID-19 crisis. The bad news, however, is that the deal’s remedy for big distressed corporations—businesses with more than 10,000 employees—is a large-scale lending scheme. Even worse, the Federal Reserve has doubled down on lending, with the announcement of plans to expand corporate debt backstops through the purchase of junk bonds.
Even with the Fed’s latest move, the need for additional stimulus measures is becoming clearer by the day. The current approach burdens companies with debts that could jeopardize their own recoveries, unleashing further unemployment and other challenges for the broader economy, such as prolonged supply-chain disruptions and lost tax revenue from failed businesses. Problems that would in effect nullify the relief effort.
As lawmakers mull the need for another relief package, they should move away from lending and instead support large corporations by facilitating government purchase of preferred stock, which offers companies a faster route to plugging holes in their cash reserves and puts them in a stronger position to rebound once normal economic activity begins to resume.
One issue with making big loans at low interest rates is that some corporations may use the loans for purposes unrelated to the current crisis, such as stock buybacks. Though the CARES Act prohibits that, the law gives broad discretion to the Fed and the Treasury Department, which are unlikely to saddle the structure of the program with too many regulatory conditions—meaning that other self-serving uses of funds, like boosting executives’ pay, could be fair game. What’s more, the recent dismissal of the oversight panel’s chair has cast doubt on the administration’s interest in enforcing restrictions on the stimulus spending.
Since many corporations—even healthy ones—are scrambling for loans, it will be difficult for the government to sift through an influx of applications to determine, within a short time frame, which companies most deserve help.
And government lending, of course, adds to corporate debt. Meeting obligations to repay that debt in the future may create liquidity problems and divert a corporation’s cash away from payrolls or more socially valuable expenditures, particularly in a period of recovery.
What this crisis requires is a solution that ensures funds go to the companies that actually need them, quickly, and without unintended consequences. In crafting a new support package, policymakers should recognize the flaws of large-scale lending and consider an alternative: The U.S. government (either the Fed, the Treasury, or another new entity) should buy newly issued preferred stock of publicly traded corporations.
Unlike common stock, preferred stock carries no vote, but payouts to holders of preferred shares cannot be lower than payouts to holders of common shares; this often means guaranteed dividends and other provisions that make the preferred shares less risky in exchange for the absence of voting rights. A preferred stock solution would enable the government to get cash to corporations quickly, limiting what would otherwise be a flood of bankruptcies that the U.S. courts and distressed finance sector simply could not handle.
This approach also levels the playing field by de-incentivizing government support for corporations that don’t really need it. While healthy corporations could receive loans under the current program to bolster their security nets, they would likely stay away from selling preferred shares so as to avoid diluting the company’s capital.
While government loans increase a company’s leverage—and therefore limit potential future borrowing—an equity issue decreases a company’s leverage, making it easier to secure further loans from other sources, avoiding a rise in future liquidity problems.
Making preferred stock purchases a key element of the way forward could also help the U.S. government reap massive profits down the road. Many of the 2008 to 2009 bailouts allowed the government to receive stock. The American International Group (AIG) bailout, in particular, gave the government substantial equity participation in return for bailout money and generated a considerable amount of money for the government—$22.7 billion by the Treasury’s count.
That leaves one important detail: the price. Typically, the market value of preferred shares is lower than the market value of common shares. Negotiating the appropriate discount for each company could lead to costly delays, especially given the ongoing market volatility. Pricing the preferred stock at the same level as—or as close as possible to—common stock would simply save time. Under the CARES Act, businesses large and small across the economy will receive massive financial support from the federal government. As lawmakers ponder on a fourth-phase stimulus package, they should take time to craft a better solution for large listed companies—one that gives struggling businesses a much-needed cash injection without leaving them or the government tangled in a web of debts that may never be paid off.
Ken Judd is a senior fellow at Stanford University’s Hoover Institution.
Karl Schmedders is a professor of finance at the International Institute for Management Development (IMD) in Lausanne, Switzerland.
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