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Today I’m going to discuss the why the small business lending program is undergoing intense scrutiny, and why the much larger Federal Reserve programs are not. To be put it differently, Boeing just got a $25 billion bailout from the Federal Reserve, but politicians are mad at Shake Shack.

First some housekeeping. I was on The Realignment podcast with Saagar Enjeti & Marshall Kosloff. I also joined Francesca Rheannon for her podcast titled a Writer’s Voice.

And now…

Complexity as Cover

There’s been a feeding frenzy among reporters about the small business lending program. Money is going to recognized brand names like Shake Shack and Ruth Chris who don’t seem to need it, with a fair amount of self-congratulatory rhetoric when these corporations return their loans. But I think this anger, while not exactly wrong, is misplaced. People know *something* is wrong with the Coronavirus rescue, and the Small Business Administration’s Paycheck Protection Program gives them an easy set of targets they can relate to. So that’s what gets criticized.

But the right place to focus is not on the SBA, but on the Federal Reserve, which is where the action is. That’s where lending programs are in the trillions, not billions or millions. Yesterday, for instance, the Fed decided to bail out highly indebted drilling companies and their lenders at the behest of Texas politicians, without much notice. Boeing also announced with a splash that it will be turning down an official government bailout, while borrowing a whopping $25 billion from the Federal Reserve-supported corporate bond market.

One reason for the comparatively limited criticism of the central bank’s actions is that the Federal Reserve programs are weird and complicated, involving strange words like liquidity and high yield debt ETFs.

But I don’t think the asymmetry in criticism is purely a result of difficult-to-parse jargon or capital markets complexity. It’s just easier to see what the small business lending program is doing. There’s a legal process that connects the borrower to a bank and to the government. The Fed bailouts by contrast are indirect; technically the Fed hasn't started allocating much, if any, money yet. It’s hard to point fingers at the Fed for doing something wrong when its programs haven’t even gotten off the ground.

And yet that’s a problematic way of seeing the Fed. Unlike with the small business lending program, the Fed announcement, not the initial program implementation, is what matters; just the prospect of the Fed intervening has huge impacts on borrowing costs for corporations, as well as on the prices of stocks and bonds. I’ve spoken to several people in the credit markets who tell me there is no real credit analysis anymore, traders buy what they think the Fed will backstop, meaning the Fed is giving massive implicit subsidies anywhere Jay Powell even day-dreams about intervening. In other words, many large financial actors - like Boeing - are getting billions of dollars from the Fed without any direct line to the Fed at all.

To cut through the noise, I want to try and quantify the subsidy the Fed is offering with a single case study. The ultimate numbers I’ll arrive at are a guess, but going through the exercise will help people understand that the Fed is just giving money to preserve the value of bonds and stocks. The best example is not Boeing, because there’s no easy way to calculate the implicit subsidy, even though we can assume it is very large. Carnival Cruise Lines serves the purpose better, because they were about to borrow on excruciatingly painful terms, but were saved in the nick of time by a Fed announcement. This situation gives us a nice natural experiment through we can see the implicit subsidy at work.

Carnival’s Subsidy

Four days ago, Matt Wirz at the Wall Street Journal reported a story on how the Federal Reserve saved Carnival Cruise lines. It’s told with drama, but essentially is about how Carnival was desperate to get any loan on any terms, until the Fed stepped in.

With financial markets frozen, executives were forced to consider a high-interest loan from a band of hedge funds who called themselves “the consortium.” The group included Apollo Management Group, Elliott Management Corp. and other distressed-debt investors that sometimes take over the companies they lend to, people familiar with the matter said.

Apollo Management Group and Elliott Management are cut-throat lenders. Here’s what happened next.

That all changed on March 23 when the Federal Reserve defibrillated bond markets with an unprecedented lending program. Within days, Carnival’s investment bankers at JPMorgan Chase & Co. were talking to conventional investors such as AllianceBernstein Holding and Vanguard Group about a deal. By April 1, the company had raised almost $6 billion in bond markets, paying rates far below those executives had discussed just days earlier.

There are a couple of other reporters who covered what happened, including Lawrence Strauss at Barron’s and Robert Smith at the Financial Times, and while the amounts are unknowable, it’s evident the Federal Reserve gave a large implicit subsidy to the corporation.

I’ll walk you through how we can tell. The original loan offer from the Apollo/Elliott vulture funds was hugely expensive, a high interest rate (15%), likely high upfront fees, likely an ownership stake and first dibs on all the ships and property of the company should the loan go bad, as well as the first-born child of the CFO. (Just kidding. But not really, it is Apollo and Elliott.) Once the Fed got involved, Carnival got a much cheaper if still expensive loan of 11.5% on $4 billion, plus a $1.75 billion loan that could convert into an ownership stake. That’s a significantly lower cost loan, and the cost differential between the first offer of the vulture funds and the second offer after the Fed got involved is a subsidy.

But there’s more. Because Carnival could borrow money cheaper, according to public reporting it ended up having to sell a much smaller chunk of itself, $500 million, rather than the $1.25 billion it initially contemplated. Avoiding this issuance is an implicit $750 million subsidy to the corporation and bolsters returns of Carnival's existing investors, who stood to own much less of the company had the company sold a larger stake to Apollo/Elliot. (Instead, 8% of Carnival is now owned by the Saudis.)

Another way to measure the subsidy is to look at the company’s stock value. From March 23 to today, Federal Reserve action stabilized and increased the total market capitalization of Carnival Cruise Lines from $9B to 12.5B. The Fed indirectly provided 3.5B of shareholder value. So I’ll put my guess as to the total subsidy at $3 billion.

And remember, all of this happened without the Fed buying a single bond or lifting a finger beyond putting out an announcement that they intend to backstop a market. A central bank announcement of intent itself provides a subsidy.

Now, you may vehemently disagree with my estimate, which is fine. (The eventual deal did include a convertible bond, so my equity dilution bit could be problematic. I’m quite curious how you’d value this implicit subsidy, so email me if you have different thoughts.) Can I say this amount is surely the Fed subsidy? No. There is no way to calculate it based on the information in the public domain, and even if we knew the terms of the offers, Carnival never accepted the vulture fund proposals so we can’t say for sure that a deal would have gone through. These subsidies are nowhere near as clean to understand as a direct $20 million loan going to Ruth Chris. But still, a $3 billion payout to Carnival Cruise is a lot of money, and it’s a straight-up subsidy, not a small business loan. Moreover, it’s not a one-off; other corporations, like Ford, Delta, Airbnb, Boeing, and Marriott are borrowing at reduced costs.

Is this subsidy unfair? That is a more complicated question, and has policy implications.

A Planned Economy

It would be easy to scream about Carnival getting ZOMG TAXPAYER MONEYZ!?!? just as a lot of reporters have over the small business program. I was trained in politics during the financial crisis, so I’m inclined to see these bailouts as corrupt corporate seizures of power. But I don’t want to fall into recency bias and assume that this crisis is exactly like the last one. It’s not.

I’m seeing recency bias in the disdain for the small business lending program. Attacking small business lending subsidies to business enterprise in pandemic strikes me a bit like the left-wing version of Reagan’s obsession over welfare queens. Yeah sure there’s some abuse of the program, but most people getting welfare needed it and weren’t abusing it.

With big business, the situation is somewhat, but not entirely, different. Certainly there are reasons to disdain the cruise industry in particular; cruise companies set themselves up as foreign entities so they can avoid American maritime rules and taxes, but then when there’s a need for assistance they become as American as apple pie. And taking on risk as an investor should mean there’s a downside as well. Such an attitude also applies to Boeing, which as I noted last July was going to require an eventual bailout.

No corporation, big or small, caused this pandemic, and no support means that a lot of corporate assets become part of giant private equity portfolios. That’s not good. But at the same time, the Fed and therefore the public is supporting the stock and bondholders and executives of Carnival Cruise Lines/Boeing, as well as the stock and bondholders of other large corporations. That’s a distributional choice, because those who own financial assets, and corporate executives, are already quite wealthy. Since the public is supportive of stock and bond holders, it should get some say over how those corporations operate.

Political leaders Elizabeth Warren, Alexandria Ocasio-Cortez, and David Cicilline have all called for a broad merger moratorium during the pandemic. That is a good example of a needed policy choice; it simply doesn’t make sense for Fed-supported corporations to use that support to increase their market power. And since the Fed subsidy is implicit and broad-based, the policy should be broad-based and apply to everyone.

But all of the focus on capital markets, stocks and bonds, mergers, and so forth, moves us away from the core problem. Carnival Cruise lines is in very deep trouble, and not because of the bond markets. In fact, based on another part of the article, it seems very unlikely to me that Carnival is going to remain solvent, despite this subsidy. Carnival’s Chief Financial Officer David Bernstein, wrote the Wall Street Journal, calculated the company needs $1 billion a month “to cover customer refunds, debt payments and operational costs.” A $6 billion bond issuance will work for six months. So what happens if cruise lines don’t actually go back to normal in six months?

And that’s the basic dynamic, everywhere. In large swaths of society, there are corporations with stockholders, employees, bondholders, managers, and so forth, but with no customers. That’s true for small businesses getting PPP funding, and it’s true for large businesses getting implicit subsidies from the Fed. In fact, one way someone described capital markets activity to me is as a sort of artificial play-acting, with banks and traders issuing stocks and bonds and trading them against a real economy whose respiratory system has stopped functioning. The Federal Reserve, in this case, is acting as a sort of artificial breathing machine, or ventilator, moving oxygen in and out of the economy, in a way that is both necessary and unhealthy, especially the longer it goes on.

In other words, we are in a planned economy, with the Federal Reserve and Congress explicitly choosing which business enterprises get to continue having working capital, and which ones don’t. Making these choices is necessary, because there is just a lot less activity in the travel, transportation, elective surgical, non-home based entertainment, aerospace, and oil sectors. In this situation, bankruptcy, bailouts, and lending programs all kind of fuse into the political choice of what kind of institutions we want to retain. But the longer this planned economy framework goes on, the more anger there will be as choices to retain a status quo that no longer exists looks more and more like favoritism to stock and bondholders who own what should be worthless paper.

It’ll take a few more months to realize where we are as a society. Right now our political leaders still assume that we should try and preserve the status quo as best we can, without realizing that protecting that status quo means arguing about who gets to own or profit from a corporation when there is no underlying economic activity.

And that means we have to come to a new political arrangement of what kind of society we want to live in. In the short-term, over the next six months, there’s a shared understanding that we must build some sort of infrastructure to reopen society while managing the disease, expanding things like testing and tracing, new treatment options, and regularized quarantining facilities. But soon we will have to get used to doing something that our democracies haven’t done for a long time, which is to figure out how to direct a large group of unemployed people and a lot of unused resources. Or to use a better example of the mismatch issue, preserving the pre-pandemic status quo in this pandemic means preserving a system wherein farmers destroy surplus food while many people suffer from hunger. That will not go on for long.

Choosing what kind of society in which we want to live means realizing that now is the time to mobilize resources and manpower and build, as Marc Andreeson put it, something new. I suspect, based on Republican interest in re-shoring supply chains from China and Democratic interest in addressing climate change, it’s possible to find some sort of deal where we do in fact do that. The alternative is to moan about bailouts, getting more and more sullen and angry, and then find ourselves in 2025 in an even more fragile social order.

Thanks for reading. And if you liked this essay, you can sign up here for more issues of BIG, a newsletter on how to restore fair commerce, innovation and democracy. If you want to a book to hunker down, read my book, Goliath: The 100-Year War Between Monopoly Power and Democracy.

cheers,

Matt Stoller

P.S. Last week I included a note from an experienced municipal bond investor who said we are track for a wave of defaults like nothing we’ve ever seen. Here’s a response from another reader.

Still digesting all this but wanted to point out some of the counterargument - in reference to the writer concerned about the muni market:
1. Similar scenario unfolded years ago in relation to Detroit and Puerto Rico, which was a big muni issuer. But the various asset managers like Blackrock, who control up to 50T of the investments affecting our economy, quietly got congress to help sort things out in a way where very few investors in the most common bonds got hurt at all.
2. The areas of the market mentioned as problematic (eg hospitals and housing revenue bonds) have been understood as problematic for years and were downgraded even before the pandemic. Compare these sectors to water and sewer revenues, and/or to GO bonds.
3. Many bonds carry insurance, providing double protection to investors. And the availability of insurance can be viewed as an indication of where insurers thought the problems might be in a general economic decline. The health of the insurers needs to be a matter of inquiry now, but note that the structures of the ratings and insurance were (presumably?) updated to reflect whatever might have been learned from the fixed income collapse in 2008-9.
A Chicago water bond description is attached (see below). Even today its rated AA2 - effectively the same as US treasury debt. This bond's revenues come from the willingness of people to pay for water - an essential of life. As an investor, I'd be liking that now.
An interesting investment to think about now is NY's MTA bonds. Obviously, if we let the subways go bankrupt this is not going to be a good investment. But the yields on even the 2 year paper are way up and ratings are still ok (moderate investment grade) right now. Although the ratings haven't been decreased yet, they are on negative watch for a decrease, as well as many other muni issues. Parallels abound to so many previous eras, but I'm not sure the state and city have the same structural problems they had in the 70s. Among other differences, the interest rates (and corresponding levels of debt service) were much higher then.
I'm not saying all is rosy or fine, just pointing out some other factors here.

BIG by Matt Stoller

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