(Bloomberg Opinion) -- The Federal Reserve has done much to support markets, stabilize financial conditions and backstop key areas of the U.S. debt and credit markets. But challenges remain. One big one is to get its Main Street Lending Program up and working well. As the Fed describes it, this program “is intended to facilitate lending to small and medium sized businesses” by banks and savings and loans. The program envisions as much as $600 billion of borrowing from a special Fed facility backstopped by $75 billion of Treasury funding.
The program consists of two parts: the Main Street New Loan Facility and the Main Street Expanded Loan Facility. The former would provide new loans to eligible borrowers and the latter would provide funds to increase the size of loans made before April 8.
Businesses with as many as 10,000 employees or up to $2.5 billion in annual revenue who didn't participate in the Fed’s Primary Market Corporate Credit Facility would be eligible.
Loans would be divided, with 95% held by the Fed’s lending facility and 5% retained by the lender. The 5% share is designed to ensure that the lender has “skin in the game” and therefore does a prudent job in underwriting the loan. The Fed is essentially outsourcing most of the underwriting decisions to lenders.
The loans would mature in four years and range from $1 million to $25 million. No repayment of principal or interest would be due in the first year and there would be no prepayment penalty.
If the Fed gets the balance right, the program will support the extension of credit to viable smaller and medium-sized enterprises. By taking the bulk of the loans on its own balance sheet, the Fed will expand the capacity of the banking system to lend. However, if the Fed gets the balance wrong, it may find the facility either neglected or, at the other extreme, flooded with bad loans.
The design of the lending facilities faces two hurdles. The first is to ensure prudent loan underwriting. Keeping bad businesses afloat just makes it more difficult for more viable companies to survive and prosper. The second is terms that ensure banks will lend and viable businesses will borrow.
It will be hard for the Fed to thread this needle. Consider what it will take for lenders to extend credit that's consistent with the Fed’s and the Treasury’s risk tolerance. If the loan is truly an attractive credit, there's little reason to farm it out to the Fed. Why not just keep the loan on its own books or syndicate the credit with other lenders?
In contrast, if the loan is less attractive, why would a lender want to take the risk? Here the answers may be less than reassuring. One reason is that new funding will keep the business going for a while, letting it meet its other obligations -- including, perhaps, to the lender originating the loan. Throwing good money after bad may be more attractive when most of the good money belongs to someone else. In the same vein, the loan may be unattractive on its own, but as part of a broader banking relationship it might make sense. Finally, the restraints on the use of the loan proceeds may be difficult to enforce. What is to prevent the borrower from using a loan from Bank A to repay obligations to Bank B, and a loan from Bank B to repay obligations to Bank A?
Another problem is the “one size fits all” approach to the limits on leverage. How much leverage is too much depends on the type of business and how that business has been affected by the coronavirus pandemic. The debt-to-ebitda limit of four times for the Main Street New Loan Facility may be too low for some types of borrowers (they may have already been above that limit in 2019) and too high for others. Consider, for example, the difference between a supermarket chain, an essential service that's open, versus a restaurant company, that's closed. Adverse selection might result: Highly leveraged borrowers with stable cash flows may be ineligible to participate while borrowers that were less leveraged in 2019 but in much greater trouble today can get funding.
Also, it is not clear that the program ensures a level playing field for prospective borrowers. If a smaller business has borrowed mainly outside the banking system in the past, how amenable will banks be to lend to such a company compared with a business with an established lending relationship?
Finally, the Main Street Lending program imposes a number of constraints on borrowers. In addition to restricting how the loan proceeds can be used, the eligible borrower must try to keep its payroll intact during the term of the loan and follow the compensation, stock-repurchase and capital-distribution restrictions that apply to direct loan programs under the $2 trillion CARES Act. Borrowers that are in relatively good shape will want to avoid these types of constraints, meaning the potential pool of borrowers might be made up of riskier businesses.
The Fed's goals for the Main Street Lending program are admirable: It's meant to fill a gap between the Small Business Administration loans available to small businesses and the support the Fed is providing for the corporate bond market, which benefits large corporations. But getting the balance right is going to be challenging.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Bill Dudley is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.
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