Differences Between the Coronavirus Economic Crash and 2008 Financial Crisis

Photo by Jamie Street on Unsplash

This post will address the ways in which the coronavirus crash is different from the 2008 financial crisis and why these differences matter. The most apparent difference is that the coronavirus crash has been largely self-inflicted while the 2008 crisis was characterized by a downturn in real estate markets. Moreover, the 2008 crisis was particular to the U.S. (though the cascading effects were felt globally). This is the first time in history that we’ve witnessed a global shutdown of the economy at scale and all countries have essentially opted in to this shutdown of the economy via public health policy decisions. To put it simply – the economic crisis has been subordinate to the public health crisis and this is unprecedented.

2008 In Perspective

As mentioned above, in 2008 we witnessed the impact of financial uncertainty resulting from a downturn in real estate markets. The primary cause of this downturn can be attributed to the subprime mortgage funding markets. When borrowers were no longer able to afford their subprime mortgages, the balance sheets of major banks collapsed. This was compounded by the excessive use of leverage, which resulted in a chain of defaults throughout the financial sector. This was an unprecedented financial shock at the time and it resulted in the contraction of economic activity. Between 2008 and 2009 we saw more than 750,000 job losses per month. This is resulted in a total of 8.7 million job losses over the course of the entire recession.

Major American companies ran the risk of going bankrupt and the ramifications in the global economy were profound, leading to the largest contraction in international trade recorded at the time. The crisis required significant government intervention in terms of monetary and fiscal policy to avert a prolonged recession. Interest rates were slashed, we witnessed the introduction of quantitative easing, and the Troubled Asset Relief Program (TARP) was implemented to remove toxic asset from bank balance sheets. As a result of this unprecedented effort, an economic recovery began in the back half of 2009. Ultimately, the 2008 financial crisis is a story about, as Steve Eisman puts it, “leverage being mistaken for genius.”

The Coronavirus Crash Thus Far

It’s still too early in the game to predict with any level of certainty what the ramifications of this economic downturn will be, but a recession certainly feels inevitable. The prior crisis was particular to banking institutions and decisions they had made; the current crisis is embedded in the real economy as we are deliberately shutting down the world’s major economies for a period of at least several months – perhaps longer. This deliberate action has, in my opinion, exposed a significant flaw in our financial system. Similar to 2008, it is apparent that leverage has once again been mistaken for genius. This time, however, it isn’t the banks that are over leveraged – it’s the corporate sector. The decision to shut down the U.S. economy has resulted in a liquidity crisis for several large firms, most notably in the airline industry. Moreover, the reason many of these firms lack the liquidity to weather the shutdown is because they have spent significant amounts of their earnings on stock buybacks and the results have been catastrophic.

As of March 24, 2020 there has been ~6.6 million unemployment claims filed. This is rapidly approaching the total amount of job losses we saw in 2017. This has again lead to unprecedented actions taken in the spheres of monetary and fiscal policy. The Fed, in addition to cutting interest rates down to zero, have an enacted a policy many are referring to as “QE infinity” as there appears to be no end in sight to the amount of money they will deploy in the economy during this crisis. As it relates to fiscal policy, last week we saw the passage of the Coronavirus Aid, Relief, and Economic Security (CARES) Act. This is a truly historic stimulus package totaling $2TN that includes economic stimulus for individuals, small business owners, non-profit organizations, and large corporate employers. Additionally, the act prohibits the use of stock buybacks for any publicly traded company that accepts proceeds from the stimulus package.

Conclusion

The market’s reaction to the radical new monetary and fiscal policies has been relatively stable (i.e. sell offs slow down and individuals begin purchasing stocks again), but the market is still highly volatile and susceptible to shocks. Until a solution is provided to the public health concern the market will remain unpredictable, and it is still unclear how the economy will recover once the shutdown comes to an end. However, one thing is for certain – this crisis has fundamentally altered the way we conceive of markets and the use of leverage. It will be interesting to see what comes into play after the dust settles.

As always, thank you for taking the time to consider my perspective. If you found this content valuable, please remember to like, subscribe, and share it with others.

SBA’s Payment Protection Program – What You Need to Know

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Last week I discussed the differences between monetary policy and fiscal policy and framed both within the context of the COVID-19 pandemic. This week I thought it would be beneficial to provide an overview of the SBA’s new Payment Protection Program, since this is a good contemporary example of fiscal policy in action.

The Payment Protection Program (PPP) is part of the broader CARES Act that was approved by Congress last week. This program is specific to small business owners and has been implemented with the aim of providing payroll relief in the form of low interest loans, so small business owners can retain employees. In addition to employee retention, the PPP also allows loan proceeds to be used for mortgage payments, utilities, health insurance, and retirement contributions. Moreover, so long as borrowers can demonstrate that they have allocated loan proceeds to eligible uses, they will be eligible for loan forgiveness. A more detailed overview of the PPP is provided below.

Summary

The PPP authorizes up to $349 billion in forgivable loans to small businesses to pay their employees during the COVID-19 crisis. All loan terms will be the same for everyone. The loan amounts will be forgiven as long as:

  • The loan proceeds are used to cover payroll costs, most mortgage interest, rent, and utility costs over the 8 week period after the loan is made; and
  • Employee and compensation levels are maintained.

Payroll costs are capped at $100,000 on an annualized basis for each employee. Due to likely high subscription, it is anticipated that not more than 25% of the forgiven amount may be for non-payroll costs. Loan payments will be deferred for 6 months.

Eligible Borrowers

All businesses – including nonprofits, veterans organizations, Tribal business concerns, sole proprietorships, self-employed individuals, and independent contractors – with 500 or fewer employees can apply. Businesses in certain industries can have more than 500 employees if they meet applicable SBA employee-based size standards for those industries (click HERE for additional detail).

For this program, the SBA’s affiliation standards are waived for small businesses (1) in the hotel and food services industries (click HERE for NAICS code 72 to confirm); or (2) that are franchises in the SBA’s Franchise Directory (click HERE to check); or (3) that receive financial assistance from small business investment companies licensed by the SBA. *Additional guidance may be released as appropriate.

Eligible Purposes of the Loan

You should use the proceeds from these loan on:

  • Payroll costs, including benefits;
  • Interest on mortgage obligations, incurred before February 15, 2020;
  • Interest on mortgage obligations, incurred before February 15, 2020; and
  • Utilities, for which services began before February 15, 2020.

A Deeper Look at Payroll

Eligible payroll costs include the following:

  • Salary, wages, commissions, or tips (capped at $100,000 on an annualized basis for each employee);
  • Employee benefits including costs for vacation, parental, family, medical, or sick leave; allowance for separation or dismissal; payments required for the provisions of group health care benefits including insurance premiums; and payment of any retirement benefit;
  • State and local taxes assessed on compensation; and
  • For a sole proprietor or independent contractor: wages, commissions, income, or net earnings from self employment, capped at $100,000 on an annualized basis for each employee.

Max Loan Amount and Number of Loans

Eligible borrowers will only be allowed to qualify for one loan; however, these loans are unique to individual businesses and the SBA has waived its affiliation basis requirements. Therefore, borrowers with multiple businesses will be able to apply for relief on a business by business basis – so long as the loan request(s) are in line with the eligible payroll applications.

Loans can be for up to two months of your average monthly payroll costs from the last year plus an additional 25% of that amount. That amount is subject to a $10 million cap. If you are a seasonal or new business, you will use different applicable time periods for your calculation. Payroll costs will be capped at $100,000 annualized for each employee.

Loan Structure

PPP loans will be fixed at 0.50% for the life of the loan. The maximum allowable term will be 2 years. All payments are deferred for 6 months (however, interest will continue to accrue over this period). There are no prepayment penalties for these loans, no collateral is required, and the personal guarantee has been waived.

How to Apply

You will need to complete the Paycheck Protection Program loan application and submit the application with the required documentation to an approved lender that is available to process your application by June 30, 2020. Click HERE for the application.

You can apply through any existing SBA lender or through any federally insured depository institution, federally insured credit union, and Farm Credit System institution that is participating. Other regulated lenders will be available to make these loans once they are approved and enrolled in the program. You should consult with your local lender as to whether it is participating. Visit www.sba.gov for a list of SBA lenders.

Starting April 3, 2020, small businesses and sole proprietorships can apply for and receive loans to cover their payroll and certain expenses through existing SBA lenders. Starting April 10, 2020, independent contractors and self employed individuals can apply for and receive loans to cover their payroll and other certain expenses through existing SBA lenders. *Other regulated lenders will be available to make these loans as soon as they are approved and enrolled in the program.

Required Certifications

As part of the application process, borrowers must certify in good faith that:

  • Current economic uncertainty makes the loan necessary to support your ongoing operations.
  • The funds will be used to retain workers and maintain payroll or to make mortgage, lease, and utility payments.
  • You have not and will not receive another loan under the program.
  • You will provide to the lender documentation that verifies the number of full-time equivalent employees on payroll and the dollar amounts of eligible payroll costs.
  • Loan forgiveness will be provided for the sum of documented eligible payroll costs. *Due to the likely high subscription, it is anticipated that not more than 25% of the forgiven amount may be for non-payroll costs.
  • All information provided in your application and in all supporting documents and forms is true and accurate. Knowingly making a false statement to get a loan under this program is punishable by law.

Conclusion

This is arguably the most comprehensive relief package put together by the Federal Government and it is designed with the primary goal of ensuring small businesses are able to retain their employees and maintain essential overhead during these uncertain times. Moreover, the underwriting guidelines for this program have been significantly relaxed to maximize utilization of the program and empower lenders to close transactions efficiently.

If you know any small business owners that would benefit from this program, please share this post far and wide! If you are a small business owner, I hope this post was helpful and that you take advantage of this program and get access to much needed relief.

Monetary Policy: Key Takeaways

This picture was sourced from Pepi Stojanovski on Unsplash

The Covid-19 pandemic has introduced an era of profound strife and uncertainty. In the simplest terms, this pandemic has created two huge problems in the areas of public health and economics. To make matters worse, these public policy domains are, generally speaking, at odds with one another. This post will focus on the economic dimensions of this crisis at a high level.

When a national economy experiences macro level shocks there are two primary policy tools at the disposal of government and quasi-government actors – Monetary Policy and Fiscal Policy. The former is focused on addressing interest rates and the supply of money in circulation, it is generally managed by a central bank (such as the Federal Reserve). The latter addresses taxation and government spending, it is generally determined by legislation. Specifically, this post will proved an overview of monetary policy and explain how it is utilized by the Federal Reserve to promote certain outcomes within the national economy.

Monetary Policy

Monetary policy is typically carried out by Central Banking authorities, in the United States it is carried out by the Federal Reserve – often referred to as “The Fed.” Monetary policy involves two primary actions:

  • Establishing base interest rates.
  • Influencing the supply of money (most often carried out through policies of “quantitative easing” which increase the supply of money in the nation.

The Fed has typically used monetary policy to stimulate the economy or check its growth. When the Fed cuts interest rates, it’s sending a signal to individuals and businesses that they should borrow money and spend it in the economy. Conversely, when the Fed increases interest rates the aim is to encourage saving, rather than spending. This acts as a brake on inflation and other issues associated with rapid growth.

More specifically, the Fed has looked to three primary policy levers when influencing rates and borrowing activities – Open market operations, changing reserve requirements for other banks, and setting the discount rate.

Open market operations refer to measures carried out on a daily basis. These operations occur when the Fed buys or sells U.S. government bonds, thereby injecting or withdrawing money out of the national economy.

The second, changing reserve requirements, relates to the percentage of deposits that banks are required to keep in reserve (i.e. cash on hand at any given time). The key takeaway here is that through it’s control over reserve requirements, the Fed is able to directly influence the amount of money created when banks make loans to individuals and businesses. This is important to keep in mind in the present, as reserve requirements have become relatively lax.

Finally, the Fed has dominion over the discount rate. The discount rate is the interest rate the Fed charges on loans it makes directly to financial institutions. The key takeaway here is that the discount rate has an overarching impact on short-term interest rates across the entire national economy.

Conclusion

Ultimately, monetary policy is more of a high level tool. It’s focus lies on expanding and contracting the money supply while influencing borrowing and saving behaviors, however it has less of an impact on the real economy. The key takeaway with monetary policy is that it exists to dictate banking behaviors in the national economy through its control of interest rates and the money supply.

In normal times, the Fed’s focus will be placed on contractionary or expansionary measures. In times of crisis, however, their focus shifts to providing enough liquidity in the financial system to maintain solvency. This, in large part, helps explain the measures taken by the Fed over the last couple of weeks.

If you made it this far, thank you for taking the time to read this! I will be following up on this post with a post that provides a similar overview of fiscal policy. If you found this information valuable, please like and share it with others.

Covid-19 & Financial Markets

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As Covid-19 (Novel Coronavirus) continues to spread through the global system, and increasingly through U.S. metros, the financial markets have certainly taken notice. Volatility is on the rise and major indices have dropped as much as 11% over the course of this week. Many practitioners, government officials, and pundits have attempted to downplay the Covid-19 outbreak – arguing that the volatility of the market is the result of an overzealous media. The Federal Reserve, in typical fashion, cut interest rates in an attempt to stimulate the economy. It didn’t work.

So, why is the market reacting with such profound volatility? Because this is about more than finance. Contrary to popular belief, investors are not guided by the notion of lower rates being equivalent to higher market caps. As Sina Kian puts it in his recent Politico article Coronavirus: The Real Reason the Markets are Worried – “They’re worried about the human and economic costs of the virus itself. “

It’s Not About Monetary Stimulus

A phrase that is often thrown around in finance is confidence and what we’re seeing from investors in the financial markets is a lack of it. Confidence is not solely tied to stock performance in the literal sense, confidence also relates to the ability of public and private sector leaders to manage a particular set of circumstances. Up to this point, confidence in Washington has been shaken. The market (in aggregate) is looking for signs that the crisis can be addressed in a competent manner. There is nothing artificial stimuli, such as rate cuts and quantitative easing, can do to prevent the spread of a virus and that’s why these schemas have failed thus far.

The market, vis-a-vis it’s participants, is seeking tangible solutions to tangible problems. How will the government contain the outbreak and address existing cases? What is to be done about disruptions in global supply chains? How should reductions in revenue streams in key industries and in key companies be addressed in the midst of a black swan event? These are complex questions that cheap access to capital cannot comprehensively address.

Conclusion

This is a rare instance when public and private sector interests are in alignment and one in which public policy decisions will have a profound impact. Ultimately, the focus should lie on addressing the dynamics of the virus itself. This will begin to restore confidence in the financial markets and help bolster economic considerations moving forward.