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…