The case of US stimulus - distorting generosity?

The economic policy response to the Covid 19 pandemic in developed countries has been remarkable in its scale and speed. The fiscal and monetary authorities have been doing "whatever it takes" to backstop the economic declines.

The US Federal Reserve has broken all expectations with the speed and scale of its actions in response to the pandemic. On March 23, it announced $4 trillion in loans and other forms of credit. On April 9, it announced an additional $2.3 trillion in loans to support the economy. It said it would consider buying even junk bonds of companies like Ford and Kraft Heinz and high-yield exchange trade funds. It is now backstopping most parts of the debt market. Speculation is already afoot that it will do the same with equity markets if needed. 

It has inevitably sparked off the moral hazard issue. This is a good summary of the problem,

The US government has stepped in to make borrowing easier. The debt market was buoyed by the Federal Reserve’s announcement that it will buy $750bn in corporate debt, and the main street lending programme will make $600bn in loans to midsized companies. The moral hazard is obvious. When governments help indebted companies avoid bankruptcy, investors conclude that the government will always absorb debt’s tail risks. The price of debt goes down and its amount rises, yet again.

The central banks have amassed very high credibility in backstopping the financial markets, which in turn has engendered moral hazard concerns,

In 2012, the European Central Bank’s then-president Mario Draghi provided history’s most vivid demonstration of central bank power by promising to do “whatever it takes” to save the euro. Investors correctly inferred that meant lending to heavily indebted countries such as Italy and Spain, which were being locked out of bond markets. Investors quickly resumed buying Spanish and Italian debt, before the ECB had spent a penny. The Fed’s response to the coronavirus pandemic has been similar. When yields on Treasurys and mortgage-backed bonds spiked, the Fed brought them down with a flood of buying. When investors started to shun corporate debt, the Fed promised to buy it through special programs backstopped by the Treasury department. The spread on yields between investment-grade corporate bonds and Treasurys has since shrunk by about half, without the Fed buying any corporate bonds.

In a weekly newsletter, Howard Marks raises several concerns about the Fed's actions. In particular, the purpose of buying non-investment grade debt and providing relief to leveraged investment vehicles,

Most of us believe in the free-market system as the best allocator of resources. Now it seems the government is happy to step in and take the place of private actors. We have a buyer and lender of last resort, cushioning pain but taking over the role of the free market. When people get the feeling that the government will protect them from unpleasant financial consequences of their actions, it’s called “moral hazard.” People and institutions are protected from pain, but bad lessons are learned. A company uses its cash and perhaps borrows more to repurchase its shares. A corporate acquiror chooses to use more leverage rather than less. Or the organizer of a REIT or CLO takes on more debt in order to amplify its returns. In each case, the chosen tactic will magnify profits if things go well, but it’ll also magnify losses if things go poorly and reduce the probability of surviving tough times. If these parties get to enjoy the fruits of their actions when they’re successful but are protected from loss when they fail, risk-taking is encouraged and risk aversion is suppressed.

There’s an old saying – variously attributed – to the effect that “capitalism without bankruptcy is like Catholicism without hell.” It appeals to me strongly. Markets work best when participants have a healthy fear of loss. It shouldn’t be the role of the Fed or the government to eradicate it... unlikely (and even unforeseeable) things happen from time to time, and investors and businesspeople have to allow for that possibility and expect to bear the consequences. In other words, they have to think like the six-foot-tall man hoping to get across the stream that’s five feet deep on average. I see no reason why financiers should be bailed out simply because the event they’re being harmed by was unpredictable. 

And such moral hazard from Fed's actions opens up opportunities for discerning investors,

Take, for instance, Bill Ackman, the hedge fund manager. In mid-February, he started buying insurance on various bond indexes — a bet that the debt bubble would burst — based on his hunch that investors would abandon the riskier securities in those indexes as the pandemic spread from Asia to the West. His $27 million hedge was completed on March 3, and he sold his positions on March 23, the day the Fed announced its first major new intervention, for a profit of $2.6 billion. Mr. Ackman played the Fed’s moral hazard, betting correctly that until the Fed and the Congress acted, the markets would tank. And that once they did, that the markets would start to recover. (He has since plowed his winnings back into stocks.) For speed and accuracy, Mr. Ackman’s bet may be the single best trade of all time.

Besides, the Fed's extraordinary monetary easing may be amplifying the Mathew Effect that has been a feature of financial markets in good and bad times since the millennium. Sample this about the equity markets,

The Nasdaq 100, an index of the largest technology companies — which also happen to be the largest companies in the country — is down 0.6 percent this year. The Russell 2000 index, which tracks small public companies, is down 22 percent — roughly double the 11 percent in losses for the S&P 500... According to data from Goldman Sachs, the top 10 stocks in the S&P 500 this month accounted for roughly 27 percent of the total value of the index. That surpassed the previous peak, which came during the tech stock frenzy of the late 1990s. The top five companies alone — Microsoft, Apple, Amazon, Alphabet and Facebook — account for 20 percent of the index... And as bigger companies have steadily grown, they’ve also snagged a larger share of profits. In 1975, the biggest 100 public companies in the country took in about 49 percent of the earnings of all public companies. Their piece of the pie grew to 84 percent by 2015, according to research from Kathleen M. Kahle, a finance professor at the University of Arizona, and René M. Stulz, an economist at Ohio State University.

Similar concerns are mounting with the fiscal stimulus, especially the Paycheck Protection Program of small business lending, which appears to have been largely cornered by the larger firms. Sample this demand,

Private-equity firms including Apollo Global Management and the Carlyle Group, which want some of the Paycheck Protection Program bounty for their struggling, overleveraged portfolio companies. This is an outrage, of course. Private-equity firms have more than $1.5 trillion of their own capital that they could use to salvage their losers instead of hoovering up money meant for the less fortunate.

Talking about market concentration, Derek Thompson has a dire forecast of post-Covid retail trade and points to further market concentration, exacerbated by the stimulus spending,

The pandemic will also likely accelerate the big-business takeover of the economy. In the early innings of this crisis, the most resilient companies include blue-chip retailers like Amazon, Walmart, Dollar General, Costco, and Home Depot, all of whose stock prices are at or near record highs. Meanwhile, most small retailers—like hair salons, cafés, flower shops, and gyms—have less than one month’s cash on hand. One survey of several thousand small businesses, including hotels, theaters, and bars, found that just 30 percent of them expect to survive a lockdown that lasts four months. Big companies have several advantages over smaller independents in a crisis. They have more cash reserves, better access to capital, and a general counsel’s office to furlough employees in an orderly fashion. Most important, their relationships with government and banks put them at the front of the line for bailouts. 

The past two weeks have seen widespread reports of small businesses struggling to secure funds from the federal government. Larger companies do not seem to be experiencing the same delays. In one particularly controversial case, Ruth’s Chris Steak House—a public company with 159 locations and $87 million of cash on hand—announced that it had secured $20 million from a small-business rescue program that ran out of money before it could help countless independents... COVID-19 is, contrary to New York Governor Andrew Cuomo’s recent assessment, no “great equalizer.” It’s a toxin for underdogs and a steroid for many giants.

The bailout of the airline industry has perhaps been the most generous and moral hazard inducing. In a very good article Timothy Massad, a former Chairman of CFTC writes,

The aid to air carriers is particularly good for investors and costly to taxpayers because most of it -- 70% to be exact -- doesn't have to be repaid. Although all of it must be used for employee compensation, most of it is neither debt nor an equity investment; it is simply a grant. Congress authorized $25 billion for loans, and another $25 billion for “payroll support.”... Treasury decided only 30% of the total for each airline would need to be repaid, and obtained warrants for common shares for 10% of that 30%. That’s 3% of the total aid compared with 15% for warrants on the funds used to help banks in the 2008 financial crisis.

What did the airlines do and how does it place the terms of the bailout in perspective?

One day after receiving $5 billion in assistance from the Treasury, United Airlines sold $1 billion of common stock. Two days after receiving $5.4 billion in taxpayer funds, Delta said it was raising $3 billion by selling secured debt... United had about 240 million shares outstanding before last week’s offering, and it sold an additional 40 million shares at $26.50 each. Meanwhile, in return for the aid, Treasury received 4.6 million warrants. For each dollar of future stock price appreciation, legacy United shareholders will get 84 cents and new shareholders will get 14 cents. Treasury's return? Less than 2 cents per dollar of share price appreciation, and there's a catch: Treasury doesn’t get anything until the price exceeds $31.50.

Mr Massad also provides the alternative incentive compatible structuring,

It’s also good that the assistance agreements prohibit the airlines from paying dividends or repurchasing their common stock. But those same terms could have been built into a transaction in which all the assistance was in the form of a low-cost loan. Loans could have been structured to postpone principal payments and very low or no interest for three to five years, giving the industry time to recover. To best protect taxpayers, the loans also could have been secured; when Delta said last month that it was selling secured debt it disclosed that it had $15 billion in unencumbered assets. 

One way being suggested to mitigate the moral hazard is radical - take equity stakes.

But in circumstances such as today’s, why stop with just a few big firms ending up on government books? Why not take all the loans, convert them into equity, create a special purpose vehicle (or several, dividing up listed and private businesses, perhaps) and manage them for the public’s benefit. Or, for extra public support, manage them specifically for the benefit of public health services — always a winner in the UK and surely an increasingly political draw elsewhere... we might also have to rethink the idea that governments should selldown these equity stakes as fast as possible, as happened in the above bailouts. Instead, we should think about the situation as if we are building very public sovereign wealth funds...

There is some precedent of successful intervention here as well. Let’s ignore for the moment that the Bank of Japan is on track to own some $370bn of the country’s ETF market. This is intervention on a huge scale, but whether it will ever count as a success is not yet known. A more interesting example is Hong Kong in 1998. Then, as markets tanked during the Asian financial crisis, the government stepped in to calm the market and bought about 11 per centof the Hang Seng’s free float over a two-week period. Crisis averted. There is also how the US made loans to, and held stock in, thousands of distressed companies in 1932 via the Reconstruction Finance Corporation. Intervention, assuming it is both fast and big, isn’t always an obvious mistake.

Update 1 (19.05.2020)

Americans are making more from covid-related unemployment benefit of $600 per week than when they were working 

A study has found that 68% of those unemployed are getting more than their lost earnings, and the median share of the worker's salary being replaced is 134%. See also this.

Update 2 (07.07.2020)

FT calls for conditionalities to corporate bailouts in the wake of Covid 19 pandemic,

In many cases the conditions attached to the bailouts of 2008 were not meaningful — a lesson to heed today. A handful of European governments, including Denmark and France, have barred emergency cash for any companies registered in countries on the EU’s list of non-cooperative tax jurisdictions. The step may seem radical but the definition used is narrow. It excludes EU tax havens such as Luxembourg. Companies also contribute to the public purse through staff taxes and VAT, so governments can lose out if companies are not rescued. Far better would be to tie a bailout to a moratorium on dividend payments and share buybacks. This should be for a limited time only given the impact the loss of dividends would have on the pensions of individuals, most of whom have already seen their retirement income adversely affected by the collapse in equities. Excessive executive pay should also be curbed. Britain’s Investment Association has said that companies should consider reviewing long-term incentive plans and bonuses. Policymakers will need to examine the merits of any bailout of private equity-backed companies. Many were loaded with extreme levels of debt to fund the payment of large dividends to owners. The industry is also sitting on large cash piles.

Mariana Mazzucato and Antonio Andreoni call for conditional bailouts.

Both Denmark and France are denying state aid to any company domiciled in an EU-designated tax haven and barring large recipients from paying dividends or buying back their own shares until 2021. Similarly, in the US, Senator Elizabeth Warren has called for strict bailout conditions, including higher minimum wages, worker representation on corporate boards, and enduring restrictions on dividends, stock buybacks, and executive bonuses. And in the United Kingdom, the Bank of England (BOE) has pressed for a temporary moratorium on dividends and buybacks. Far from being dirigiste, imposing such conditions helps to steer financial resources strategically, by ensuring that they are reinvested productively instead of being captured by narrow or speculative interests. This approach is all the more important considering that many of the sectors most in need of bailouts are also among the most economically strategic, such as airlines and automobiles. The US airline industry, for example, has been granted up to $46 billion in loans and guarantees, provided that recipient firms retain 90% of their workforce, cut executive pay, and eschew outsourcing or offshoring. Austria, meanwhile, has made its airline-industry bailouts conditional on the adoption of climate targets. France has also introduced five-year targets to lower domestic carbon dioxide emissions.