Jeffrey Phlegar, Chief Executive Officer, has more than 30 years of experience in global fixed income management and during the Global Financial Crisis was responsible for the management of a TALF 1.0 fund along with participating in the Capital Purchase Program, Community Bank Program, and the Public Private Investment.

Steven Friedman, Managing Director and Senior Macroeconomist on the Global Fixed Income Team, has more than 22 years of industry experience including 15 years with the Federal Reserve Bank of New York spanning the Global Financial Crisis.

- The economy is in the midst of a deep contraction as a result of social-distancing mandates.

- The policy response has been appropriately oriented towards providing households and businesses with the funds to weather the shock.

- Investor-focused facilities such as TALF can also play a critical role in supporting the flow of credit.

- The reliance on emergency debt financing for the most affected industries, as opposed to preferred shares and warrants, limits the upside for taxpayers and Treasury’s influence over how funds are used.

- The Federal Reserve’s actions, while necessary, draw a “bright line” between protected and orphaned assets. This has the potential to influence the pricing of credit risk for years to come.

The United States and global economy are in the midst of an unprecedented economic shock, as countries respond to the Covid-19 crisis with social distancing practices that greatly reduce business activity and aggregate spending (the “Great Lockdown”). The resulting collapse in cash flow has left businesses and households scrambling to meet financial obligations and fund the purchase of necessities. In the US, the sudden stop in economic activity is captured most dramatically—and tragically—by the record rise in unemployment insurance claims, resulting in an unemployment rate that likely now stands at close to 20 percent (see Figure 1). High-frequency, weekly indicators of economic activity indicate a deepening contraction, and uncertainty over when and how the economy will “reopen” has led to daily gyrations across both debt and equity markets. Unlike previous economic contractions, the Federal Reserve has had limited ammunition in terms of traditional monetary stimulus and has pivoted to non-traditional forms of policy accommodation including quantitative easing (QE) and other purchase and lending facilities aimed at supporting the flow of credit to businesses and households.


No doubt, this contraction will continue until new Covid-19 infections decline sufficiently, and for an extended period of time, such that social distancing mandates can be relaxed and some semblance of normal activity can resume. We anticipate only a gradual pickup in economic activity, potentially with starts and stops until a vaccine is in place and widely available. This points towards the need for current levels of fiscal and monetary support to be maintained for an extended period.

In this environment, fiscal policy has a critical role to play in providing households and business with funds that can substitute for lost cash flow. By and large, we believe that the programs that Congress has put in place represent a meaningful step in the right direction, as they provide large corporations in the most affected sectors with financial support, put cash directly into the hands of households, and provide funds that help small enterprises meet payroll and “keep the lights on.” We suspect that the funds that Congress has allocated to many of these programs―especially for small businesses and state-level support—are not nearly sufficient, but we do not doubt the political will to make additional funds available as needed. While programs can be upsized, our main concern has instead been delays in distributing funds to businesses, many of which are in dire need of cash. Should these delays continue, it increases the likelihood that many will remain shuttered permanently, an outcome that would jeopardize the speed of the recovery and prospects for a strong bounce back in household employment. Market participants are also carefully assessing the domino effects of businesses struggling to cover obligations or potentially failing altogether, for example, the inability to make payments on leases or to suppliers.

Monetary policy has no less important a role to play in the current crisis. Federal fund rate was already sub 2%, and unlike the previous crisis the Fed had limited rate cut ammunition to address the economic pressure (see Figure 2). Importantly, the central bank can and has committed to deploy funds to prevent an economic crisis from boiling over into a financial crisis. We have been encouraged by how quickly the Federal Reserve has provided a nearly unlimited supply of dollars in secured and unsecured markets, restarted its quantitative easing program to improve market functioning and liquidity in the Treasury and agency mortgage-backed securities (MBS) market, and taken steps to reduce balance sheet pressures on banks, dealers and money market funds.


Given the nature of this shock, we have also been carefully studying the Federal Reserve’s willingness to expand its “Lender of Last Resort” safety net beyond banks, to cover primary dealers, investment grade corporates, recent and future “fallen angels” from the investment grade universe, and state, county and city governments. This expansion of the safety net will be critical in ensuring large swaths of the economy have the necessary support to weather the drop-off in economic activity. The hope and expectations are that like fiscal policy, monetary policy is helping to build a bridge over this growth chasm, improving prospects for a strong recovery later in the year. Meanwhile, inflation remains a remote risk at present given the extraordinary hit to aggregate demand. But it will become a risk in need of monitoring once fiscal policy eventually pivots to true stimulus as elected officials are confronted next year with a fitful recovery and uncomfortably high unemployment.

All told, the speed and scale of the monetary policy response has been unprecedented, greatly eclipsing the policy response during the Global Financial Crisis (GFC). In addition, the Federal Reserve’s actions represent a fundamental change in approach compared to that prior episode.

During that crisis, the central bank’s emergency facilities were largely aimed at shoring up the banks and dealers at the heart of the financial system, a process that reached its zenith with bank stress tests and recapitalizations. In contrast, the Federal Reserve is now creating programs that seek to direct funds to specific parts of the economy, tailoring the terms of these programs to incentivize banks, businesses and financial market participants towards its objective of supporting a strong recovery and enabling the flow of lending to businesses and the consumer. To be sure, many components of the approach are not entirely new. During the recovery phase of the GFC, the Term Asset Backed Securities Lending Facility (TALF) helped to restart the primary market for household loans by lending to Asset Backed Securities (ABS) investors. What is new is the scope of similar interventions, which are now aimed at supporting the flow of credit to large corporations, municipal governments, and small and medium enterprises, as well as to households. This is a radically different approach that indicates that the Federal Reserve is “ALL IN” and willing to use its balance sheet to the full extent necessary during this crisis, even taking direct credit exposure to businesses and households. This could create lasting changes in both borrower and investor behavior.

Broadly speaking, the policy responses to date can be broken down into five categories, bearing in mind some overlap across these categories (see Figure 3):

1. Cash flow replacement--Paycheck Protection Program, taxpayer rebates, enhancements to unemployment insurance (fiscal);

2. Emergency support--Grants and/or loans to airlines, air cargo firms, firms deemed critical to national security, states and cities, and public health (fiscal);

3. Monetary policy easing and market stabilization--Includes rate reductions, forward guidance, QE, repo operations and central bank liquidity swaps (monetary);

4. Lender of last resort--Temporarily extended beyond banks to include primary dealers, IG-rated corporates and recent/future fallen angels, and state and local governments (most are joint fiscal/monetary initiatives);

5. Supporting the flow of credit--TALF, Main Street Program (joint fiscal/monetary).


- Early Thoughts on Implications of Policy Responses

There is a compelling case for aggressive fiscal and monetary policy that errs on the side of doing too much, rather than too little. As investors, however, we need to consider the ramifications for markets and investment portfolios of policy choices taken in a rapidly unfolding crisis, and the trade-offs of short-term stability versus longer-term consequences. With this in mind, we do see some imperfections with the design of some of the policy responses. In particular, the reliance on emergency debt financing raises immediate issues. Direct debt purchases stabilize funding but fails to address the underlying problem of weakening capital structures and rising default risk over recent years. Alternatively, structuring cash infusions in the form of equity or preferred interests with warrants would allow taxpayers to participate in the financial upside of rescue programs and allow Treasury to exert influence with respect to the use of funds. Of course, equity alternatives would be more time consuming to implement and would inevitably face objections from the various constituents. Those corporations needing capital would have access--albeit at a price. While no one could have predicted this event, there is plenty of evidence of borrowers having stretched the envelope in recent years in terms of dividend distributions and high levels of borrowing because they could. Not diluting shareholders essentially rewards capital for poor balance sheet management in recent years. This becomes the essence of a moral hazard.

In addition, debt purchases alone fail to allow capital markets to price the requisite premium on debt obligations in a true fundamental fashion. And the reliance on debt-focused aid raises the prospect that firms will emerge from this crisis even more heavily indebted, limiting their ability to expand operations in the future. Indeed, it is hard to see how the US economy escapes from this debt trap, absent an orientation of monetary policy towards inflationary outcomes that lower debt burdens in real terms.

Make no mistake, we are very supportive of the wide safety net that the Federal Reserve has cast given the unprecedented nature of this crisis. It is imperative that well-managed firms with sound business plans emerge on the other side with as little damage as possible. But we struggle with, and question, the decision to buy high yield ETFs, which implicitly extends support to many firms with poor prospects even over a normal business cycle. Supporting such firms can lower the economy’s longer-run potential, as it hinders the reallocation of resources to more productive ends.

Programs like TALF have the potential to truly fuel credit extension to businesses and consumers. Banks and finance companies will emerge from this crisis with impaired balance sheets and constrained capacity to meet the credit needs of an economy in rebuilding mode. Through the provision of remote-risk loans in the TALF program, the Federal Reserve will incentivize investors to purchase loan pools from financial intermediaries, replenishing their capacity to continue to support the credit needs of the economy. TALF may also prove to be a much-needed complement to the Small Business Administration’s Payroll Protection Program (PPP) and the Federal Reserve’s Main Street lending facilities, which have design flaws that will limit their effectiveness.1 The inclusion of credit card receivables, equipment loans and leases, floorplan loans and small business loans as eligible collateral allows TALF to directly support the credit needs of businesses, including small family-owned businesses at the heart of many communities.

For investors, the Federal Reserve’s actions draw a “bright line” between protected and orphaned assets. This has the potential to influence the pricing of credit risk for years to come. At the very least, we would encourage policy makers to clarify for the public the rationale for the extension of the safety net to different sectors of the economy and to firms of varying credit quality. This may be clear in the abstract, i.e., a “whatever it takes” approach in the face of an exogenous shock of unprecedented speed and depth. But articulating the conditions for extending the safety net will be important in framing interventions in future recessions. Absent this guidance, too many investors will assume that future policy interventions will limit the downside of credit investing, prompting behavior from firms and investors alike that could substantially raise financial stability risks down the road. This is perhaps a discussion for another day, when policymakers have the bandwidth to think about the consequences of today’s policy actions. But as long-term investors, that is a luxury that we do not have.

As we look ahead, the clouds may look dark and the duration of this crisis uncertain. Government policy cannot fully offset the economic fallout from the health crisis, however, strong policy actions have provided much-needed relief and market stabilization. Broad provision of cash and credit to business and households will support the recovery and allow key sectors of the economy to weather current uncertainty. We take comfort in “whatever it takes”, but also emphasize the long-term considerations and strongly encourage policy makers to continue to support the consumer and enable the strength of balance sheets in a well-aligned fashion with corporate America and investors.

1The PPP is focused primarily on assisting small businesses meet payroll expenses, and only for a short period of time. While a laudable objective, ultimately the program will prove to be too limited in its support of businesses in need of financial support to scale up their activities once social distancing mandates are relaxed. Meanwhile, we are concerned that the Main Street Lending Program’s design is overly focused on protecting the Federal Reserve from losses. Ultimately, required risk retention for participating banks will limit the program’s take-up and credit availability for countless stressed businesses. This stands in marked contrast to TALF, where provision of non-recourse loans will catalyze investor interest in the program, ultimately to the benefit of households and businesses in need of credit.