Structural Challenges in the Federal Reserve’s Main Street Lending Program

Structural Challenges in the Federal Reserve’s Main Street Lending Program

May 21, 2020

Client Alert

Brownstein Client Alert, May 21, 2020

In a recent Senate Banking Committee hearing, Sen. Pat Toomey (R-PA) asked Federal Reserve Chairman Jerome Powell whether there was likely to be “strong demand” for the three credit facilities that comprise the Federal Reserve’s Main Street Lending Program (MSLP). There is no shortage of demand among small and medium-sized enterprises (SME) for bridge loans to meet obligations as revenues have fallen during COVID-19-related shutdowns. Chairman Powell’s candid response to the senator’s question foreshadowed the possibility that the MSLP may simply not work once it is launched later this month: “You should know that we will continue to be prepared to adapt, as we have shown. If the uptake is not what we would hope, then we'll be prepared to go after that and try to find ways to address the needs of this area of the economy.” SMEs have waited a long time for the MSLP to become operational; finding out the program doesn’t work when the Federal Reserve launches the program would be financially devastating to many of them.

There are two significant structural issues the Federal Reserve and Treasury Department will need to work out—soon—if the MSLP is going to provide meaningful relief to SMEs.  

  • First, like the popular Paycheck Protection Program (PPP), the MSLP once again uses the nation’s private banks and credit unions as the delivery model for new Federal Reserve-backed term loans. Unlike with the PPP, however, the MSLP requires lenders to have “skin in the game” in the form of a 5% or 15% risk retention in each SME loan. Risk retention is normally designed to prevent an originator from taking too much risk, but lenders are generally not presently making the kind of loans described in the MSLP to SMEs (if they were, we wouldn’t need the MSLP), so there is no excessive risk-taking to be cabined, especially among lenders operating in one of the most highly regulated sectors of the economy. The risk retention feature of the program thus appears to be at best ineffective or, worse, an impediment to loan origination. A lender that is not interested in making a MSLP-qualifying loan to a borrower outside of the MSLP (because the loan is unlikely to be profitable) is not going to be inclined to sign up for “only” a 5% or 15% stake in the same unprofitable loan once the MSLP launches. Lenders want to keep 100% of a profitable loan or don’t want to make it at all.

  • Second, from the perspective of many SMEs, the credit box of the MSLP (even the more generous Main Street Priority Loan Facility) is too small. Thousands of American SMEs operate with modest six-to-one leverage; the MSLP offers these companies no relief. For comparison, consider that banks are more heavily regulated today under the Dodd-Frank Act and other capital rules than they were during the last crisis and have operated very safely even during this financial crisis at approximately nine-to-one leverage. Neither does the MSLP presently offer credit to borrowers with existing asset-based loan agreements (many of the nation’s retailers), to companies capitalized with private equity, or to commercial landlords, which are getting squeezed between ongoing mortgage obligations and record shortfalls in tenant rent payments.

Many SMEs simply cannot afford to “wait and see,” a scenario in which the MSLP opens for business but welcomes only those customers that could have gotten credit even in its absence. Neither can thousands of American businesses afford to wait until the third quarter for a potentially expanded credit box. Solving for these issues may require the following changes:

  • The Federal Reserve could eliminate the risk retention requirement altogether, which would give the Federal Reserve full discretion over underwriting. This is the model used for PPP. The Federal Reserve could establish the terms and conditions of the loans it would offer without risk of lender credit overlays. Private lenders (banks, credit unions, business development companies, fintechs, etc.) would be entitled to a fee for originating the loan in accordance with strict Federal Reserve-provided guidelines and then selling the entire loan to the Federal Reserve.

  • Treasury and the Federal Reserve could consider the $454 billion appropriated to Treasury's Exchange Stabilization Fund in the Coronavirus Aid, Relief, and Economic Security (CARES) Act as invested credit loss in the program. At the May 19 Senate Banking Committee hearing, Treasury Secretary Steven Mnuchin carefully explained that Treasury’s “capital is at risk and [Treasury is] fully prepared to take losses in certain scenarios on that capital.” Of course this is true, but there is daylight between “prepared to take losses” and trying to take losses. A change in Treasury’s posture, together with an important public signal from Congress that it is willing to replenish the $454 billion if and when it is depleted, could go a long way in opening up the MSLP to thousands more SMEs. With Treasury planning to lose all the money, the Federal Reserve, operating under the lender-as-distributor-only model, would be willing to broaden the credit box and take the kind of risk on SME loans that it appears many members of the Senate Banking Committee are hoping the Federal Reserve will take in the MSLP.

Chairman Powell and Secretary Mnuchin stated at the May 19 hearing that the MSLP would be operational in late May or early June. Between now and then, the Federal Reserve will need to provide substantially more information to lenders to communicate its expectations for the program and have those terms and conditions filter down to individual loan officers. Until then, SMEs will just have to “wait and see” whether they still have a home on Main Street.

 

Click here to read more Brownstein alerts on the legal issues the coronavirus threat raises for businesses.

This document is intended to provide you with general information regarding the Main Street Lending Program. The contents of this document are not intended to provide specific legal advice. If you have any questions about the contents of this document or if you need legal advice as to an issue, please contact the attorneys listed or your regular Brownstein Hyatt Farber Schreck, LLP attorney. This communication may be considered advertising in some jurisdictions.

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