The Federal Reserve could help insure against long-lasting economic scars from the very sharp COVID-19 recession by creating a credit facility to assist large publicly-traded firms with high debt loads to move efficiently through Chapter 11 bankruptcy, suggests a paper discussed at the Brookings Papers on Economic Activity (BPEA) conference on June 25.
At the same time, the Federal Reserve could liberalize the terms of its Main Street Lending Program to better help smaller owner-managed firms avoid liquidation under Chapter 7 bankruptcy, suggest Markus Brunnermeier of Princeton University and Arvind Krishnamurthy of Stanford University.
In Corporate debt overhang as credit policy, the authors argue the Federal Reserve should design its lending facilities to address the unique challenges posed by the current recession. During the global financial crisis more than a decade ago, the Federal Reserve supported the economy by keeping credit flowing to businesses and households when the broken financial system could not. In the pandemic crisis, the Federal Reserve’s actions in March, including the creation of facilities to support the corporate bond market, effectively restored market functioning much more quickly. Large corporations, if comfortably solvent, can raise cash if they need it. Now, because the current crisis has affected different firms differently, the challenge is to target credit support where it is most needed to insure against economic scars that could linger for years, the authors say.
“2020 is not 2008. Although both the ongoing COVID collapse and the global financial crisis have led to significant economic destruction and hardship, the nature of the collapses differ in fundamental ways,” they write.
In particular, firms with already-high levels of debt, especially risky high-yield debt, are paying much more to borrow than other firms. If Federal Reserve officials expected the economy to bounce back quickly, it might make sense to support these firms. But, since the Federal Reserve is projecting that the economy will need several years to recover its pre-pandemic vigor, it is better to ensure an efficient bankruptcy process rather than subsidize firms to continue at the edge of solvency, the authors argue.
“If you let the firm continue with a high debt load, the firm is eroding along the way … laying off employees, not doing maintenance … directing whatever liquidity it has to maintaining debt service,” Krishnamurthy said in an interview with The Brookings Institution.
Chapter 11 bankruptcy, typically used by large companies in trouble, provides an automatic stay on debt payments, allowing time to negotiate debt reductions. The company’s debt and equity holders take a loss. But, in the meantime, the company continues operating and the underlying source of its value—its real estate, its equipment, its…
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