The U.S. is facing a recession in which corporate cash flow is collapsing while credit spreads on corporate debt are surging. Yet, in significant ways, the current situation is markedly different than a typical recession. While in a typical recession, cash flows may experience a decline of, say, 10%, in the current COVID recession, cash flows for some firms will temporarily fall by 100%. Importantly, the current situation should be viewed as a pause: cash flows of many of the affected firms will bounce back once the COVID recession is past. However, before the pause is over, firms may face situations where they are unable to service their debts and other fixed financial commitments. These sudden but temporary cash flow stoppages may force many corporations to file for Chapter 11 bankruptcy. But bankruptcy can lead to inefficient liquidation, a deadweight cost to the economy, which policy should aim to minimize.
The Fed has rolled out a number of new lending facilities that support the flow of credit to businesses. These measures include new funding facilities for commercial paper as well as for debt issuances in both the primary and secondary markets. Such facilities all aim to inject government risk-bearing capacity into the corporate bond market and thus reduce risk premia and bond yields.
While these programs aim in the right direction towards stabilizing the macroeconomy, their benefits will be diffused. The largest macro benefit of the Fed programs is to reduce the cost of borrowing and thus stave off bankruptcy. If, for example, Fed policy lowers the cost of rolling over debt from 10% to 5%, some corporate cash will be conserved. This savings may be enough to save some firms who are close to default. But importantly, the macro benefit is limited to avoiding deadweight costs of bankruptcy for these “at the margin” firms. Necessarily, the totality of these benefits will be small, because they apply to a set of firms much smaller than the universe of all firms.
We describe a more targeted approach to using the government’s risk bearing capacity to mitigate deadweight costs of bankruptcy. The goal is not to stop Chapter 11 restructurings from occurring, but rather to limit their deadweight costs when they do occur. There are two deadweight costs associated with bankruptcy: (i) inefficient liquidation of economically viable firms; and (ii) inefficient continuation of firms whose business models may be permanently unprofitable. In an economic pause, concern (i) is likely to be much more significant than (ii). Our policy therefore aims to minimize inefficient liquidations (while remaining mindful of (ii)).