May 4, 2020

Kathryn Judge on the CARES Act and the Political Implications of Relief Efforts

Policymakers should support bankruptcies and refocus their relief efforts on small and medium sized businesses.
David Beckworth Senior Research Fellow , Kathryn Judge

Hosted by David Beckworth of the Mercatus Center, Macro Musings is a new podcast which pulls back the curtain on the important macroeconomic issues of the past, present, and future.

Kathryn Judge is the Harvey J. Goldschmid Professor of Law at Columbia Law School, the editor of the Journal of Financial Regulation, and an expert on financial markets, financial regulation, and regulatory architecture. Kathryn joins Macro Musings to discuss the CARES Act, the Fed's role and its limitations regarding COVID-19 relief efforts, and the political implications of relief effort performance.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu.

David Beckworth: Kate welcome to the show.

Kathryn Judge: Thank you for having me.

Beckworth: I'm glad to have you on the show, Kate. Now, our paths crossed on Twitter. That's where we first met. We had some friends in common there, and we were able to meet each other and discuss some of the issues we're going to cover today. In fact, there is a group of legal scholars who focus on financial regulations, money, financial institutions, including yourself, Dan Awrey, Peter Conti-Brown, Mehrsa Baradaran, Morgan Ricks, Lev Menand, and all of you interact on Twitter, which is great. It allows the rest of us to learn from your experience, your knowledge. I'm just curious. How did this group of legal scholars who care about these issues emerge? Where did you guys all come from?

Judge: Yeah. Well, there was actually, as you mentioned, a group of us that came together really in the wake of the last financial crisis. So, I think up until that period of time, most of the people who are interested in any way in how financial markets operated, who were lawyers or legal academics, tended to end up focusing on corporate governance, or matters of securities regulation. And the last financial crisis revealed the incredible need for people who really understand finance, but also understand administrative procedure, and the institutional design that goes behind the allocation of power to different administrative agencies.

Judge: And so, you nicely summed up the group of us. I think fin reg, or financial regulatory scholars is how we might deem ourselves, but we probably ought to find a way to brand ourselves better. And it grew together fairly organically. One of the first conferences I organized was actually to celebrate Morgan Ricks and Peter Conti-Brown and Mehrsa Baradaran, who has also been on your show, each had these wonderful books out. So, it really has been an exciting decade at this point of being a part of this group of scholars that has been forging new territory and trying to understand how legal academics can contribute to these broader conversations about financial stability and accountability.

Beckworth: Yes. Now, you along with Dan Awrey and Georg Ringe, you actually started a journal, or they started a journal and you're part of it now. You're a co-editor on Financial Regulation, so tell us that story.

Judge: Yeah. I really have to give credit to my co-editors, Dan and Georg, and it grew again out of the last financial crisis, and one of the origins there was the need to have more of a cross-discipline conversation. And so, part of the aim was to create a peer-reviewed journal that was rigorous in the process for identifying high quality publications that were focused on financial regulatory and financial stability matters, but could also serve as a forum where economists could talk to lawyers, and lawyers could talk to economists and sociologists. And so, rather than shaping what we were saying to fit the confines of our discipline, we could reach outside of our comfort zone a little bit and try to speak to a broader academic audience with the idea that multidisciplinary conversation would allow us to forge new ground in trying to understand both the challenges and how we might make progress on them.

Beckworth: Yeah, and you guys are well set up for what's going on right now. I mean, you're just perfectly equipped with the tool set to talk about and think about some of the big issues we're now facing. We're going to do that today. The Fed's new programs, the legality of them, the necessity, are they well designed? And that's been great to see you discuss and talk about these topics. Before we get into it, though, there's a little bit more about your background. You have worked with the Office of Financial Research, is that right?

Judge: I'm part of their advisory council, so they have a group of outside experts, it's a mix of industry folks, and academics, and some form of policymakers, and we get together a couple times a year, and then we dive in deep in between those meetings on specific topics that they ask us to investigate. So, it's been a really worthwhile group to be a part of.

Beckworth: Yeah, it sounds very interesting. We've had a previous guest on the show, Gregg Gelzinis, and we talked about FSOC and the Office of Financial Research, and he's real upset that they haven't got enough funding and the committee itself has gotten smaller, so I imagine you've been eager to see it get more life, as well.

Judge: Yeah. I think that's one of the unfortunate challenges that we are facing, and I think there's reasons to be concerned that the failure of FSOC to bloom into everything that I think the creators of FSOC hoped it could be, and the failure of the OFR to bloom into everything that we had hoped it could do in terms of providing the informational support needed to address systemic risk and to promote resilience more broadly are going to be shortcomings that might take a toll as the current crisis continues to evolve. So, I share a lot of his concerns. I think they were very important developments, and they were a good first step to try to better address the need to address systemic risk through a fragmented regulatory structure. But there's a lot of further progress that needs to be made on that front.

Beckworth: So, are you hopeful that it will become something more after this crisis or because of this crisis?

Judge: I think that remains to be seen. I think more structural changes, at least around the margins, might be necessary for that to happen. I'm actually working separately on a task force that was put together by Brookings and Booth, and we're in the early stages of trying to evaluate these types of questions. So, hopefully you'll see more from us and that task force in a few months, or at least at the latest by early 2021.

Beckworth: Great. We look forward to that. One more question about your background before we move on to the main part of the program, and I believe you are the only person we've had on the show that has worked in the Supreme Court. You clerked for one of the justices. Is that right?

Judge: I did. I had the-

Beckworth: Wow.

Judge: The honor of spending a year with Justice Breyer, so it was a wonderful year in a whole variety of ways. And I actually think it's changed a lot of the work that I've done since then in ways I hadn't anticipated. One of the interesting dynamics of the year that I got to spend at the court was this was the year right after Justice O'Connor announced that she was planning to retire. And then when we lost Chief Justice Rehnquist quite quickly, so you had Alito and Chief Justice Roberts coming onboard, and one of the interesting dynamics that you got to see that year is how much the Supreme Court as an institution, despite being embedded deeply into the constitutional design and the extreme protections given to Article Three courts in the Constitution, was also aware of its own fragility. And very conscious in the decisions it decided, the cases it decided to take up, and the decisions that it rendered, and how it went about crafting those decisions. Trying to make sure it maintained the overall appearance of integrity despite having a meaningful change in its makeup.

Judge: So, even though from the public perspective we see these heated dissents and these controversies, part of what you get to see when you're inside is it's an institution that's very aware that credibility matters a lot, and it matters a lot to its long-term resilience. And so, I think part of my deep interest and at times concern with the Fed grows out of the recognition that we need these bodies that are not made up of directly-elected officials, but rather are other experts that we trust and we endow with power, but that legitimacy and the power that goes along with it can at times be more fragile than we want to admit or appreciate.

Beckworth: That is a great point. There's a lot of similarities between these two institutions. They both have appointments that last a long time. I mean, Supreme Court obviously is longer than the Fed, but you get 14-year appointments at the Fed. Credibility is key, right? It's important to maintaining the independence for the Fed and doing its job, its autonomy, getting the budgetary independence that it has, so it's great to see that comparison you've made there and to have your perspective from being actually inside the Supreme Court and then thinking about the Federal Reserve. In moments like these this question comes up, because what will see on the other side of the COVID-19 crisis?

Beckworth: We're in the fog of war, so understandable there's emerging fiscal and monetary policy, and we'll talk about some of the ways it could have been done better currently, but I think it's inevitable to see some of this in a crisis like this. But coming out of it, will we have to go through another Fed Accord like we saw in the 1950s, or will it be an easy transition because the Fed does have credibility? So, I think these are important issues, and it's great to have people like you thinking about them.

Judge: It's exactly why it's a great time to be studying these issues. One challenge is that when you study systemic risk and systemic crises, you actually never want your scholarship to be relevant.

Beckworth: Good point.

Judge: But the system is less resilient than we sometimes want it to be, and I think the ability to respond quickly, but also to start to think critically even in early stages about how to maintain that institutional integrity and the long-term resilience of the regulatory structure, along with the financial markets, are part of how we get through these difficult times.

Beckworth: Absolutely. Now, you have an article in Forbes titled “The Design Flaw at the Heart of the CARES Act.” It was a really great read. Saw it on Twitter. A number of people have talked about it, and I want to read your punch line. I want you to flesh it out and then explain it to our listeners. So, this is I believe your punch line from the piece, and you say, "Too much of the support in the CARES Act is going to large companies, when it should be going to the small ones. And far too many of the benefits are flowing to shareholders and creditors rather than the underlying enterprise and the people it employs." So, is that your main critique of the CARES Act and what does it mean?

Design Flaws in the CARES Act

Judge: That is my main critique, and I don't think it was intentional. I think as you go back to your term, fog of war, lawmakers were doing a really good job of trying to respond quickly and aggressively to what everybody recognized was a massive hit to the economy, and for a body like Congress, when it's moving that quickly, it has to delegate significant authority over to the executive, because it can't come up with all of the details that it needs to. And so, the question is how do you make that delegation?

Judge: And so, the idea in the article is looking at the particular method of delegation that Congress here chose, and Congress, in contrast to 2008, where effectively they gave Treasury what amounted to a blank check. It wasn't quite a blank check, but you look at how they defined troubled assets in the 2008 Emergency Economic Stabilization Act, you see they really gave Treasury a huge amount of discretion over how to go about trying to fix the financial system. And here, I think Congress for a variety of reasons, including some concerns about Treasury and not trusting Treasury quite as much, said, "Yes, we think that there is a need for significant action. We're going to authorize the Treasury Department to spend up to $454 billion supporting the economy and supporting businesses. But we're going to require all of that money to flow in or through Fed facilities created under Section 13.3."

Judge: And so, the challenges that I identified, and you did find the key sentences there, really flow from I think structural limitations in the capacity of the Fed, given its legal and institutional constraints, to get money where it most needs to go in the form that would be most valuable to helping companies, and subject to types of conditions that might be most helpful in terms of promoting the long-term health of the overall economy.

The challenges that I identified, really flow from I think structural limitations in the capacity of the Fed, given its legal and institutional constraints, to get money where it most needs to go...

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Beckworth: Yeah, so what are some of the constraints that you highlight in your article with regards to the Fed? Why is it relatively inefficient to use the Federal Reserve to get funds to the public versus Congress directly passing spending bills, making grants? What does the Fed not allow us to do very effectively?

Judge: Yeah, so I think I'd really say there's three things. One, which you've talked about previously, so I will go into in less detail, is simply the nature of the aid. As the Fed chair has repeated often and wisely, the Fed simply lacks the authority to provide grants even in circumstances where grants might be what would be economically optimal. And I think given the nature of a lot of the challenges that certain businesses are facing, a program more akin to PPP, which turns into a low-interest loan if certain conditions are not met, but otherwise has the potential to be a government grant, might be better suited to helping companies overcome some of the current cash flow challenges that they are facing.

Judge: One of the real concerns is if we end up with companies that are too loaded down with debt, even if they don't otherwise fail over the course of this crisis, they're not going to make the types of investments after the crisis that we want them to make, and so there's pretty much work on debt overhang that I'm not going to bore you and your listeners with, but I think that that is a real concern.

Judge: The second real concern is the type of companies, and here there is the primary legal constraint on the Fed is the requirement that when it's making loans, pursuant to facilities created under its section 13.3 authority, that each extension of credit must be secured to the satisfaction of the Reserve Bank. And so, that doesn't mean that the Fed can't take credit risk, but it does mean that the Fed has to take sufficient steps to have reasons to believe that those loans are adequately secured. And so, the way this works in most of the Fed's facilities, not all of them, but most of the facilities is Treasury is coming in and providing a loss-absorbing capacity equity cushion at the bottom, and the Fed is taking a senior position on top of that.

Judge: But there's still a real informational challenge over trying to figure out, "Okay, well, what companies, particularly in this current environment, are in a position where they're going to be able to pay back debt?" Well, for the large public companies, we have a very easy proxy that's available to the Fed. The Fed can say, "Well, okay, what was your credit rating?" Or, "What was your credit rating before COVID hit?" And so, it's a very ready substitute for an effort to try to assess, okay, what is the probability that this particular debt instrument is likely to pay off? And so, it's not that the Fed has any preference for large companies, but a ready substitute is available.

There's still a real informational challenge over trying to figure out, 'Okay, well, what companies, particularly in this current environment, are in a position where they're going to be able to pay back debt?'

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Judge: By contrast, when we get to some of the smallest companies, it's incredibly difficult even for banks and for fintechs that specialize in this to overcome some of the information asymmetries that impede lending to these companies. And so, for the Fed to try to set up a facility quickly that would really provide the cash a lot of these companies are going to need to survive would be quite, quite difficult. And so, it's striking that they've... One of the early facilities that they announced were the two different facilities to help the corporate credit market. By contrast, they've done almost nothing for truly small businesses, except to backstop the PPP program. And of course, in between these two extremes we see the Main Street lending facility, which is an effort to try to provide loans to mid-size companies, which they are defining as effectively companies with 500 to 10,000 employees and up to I think 2.5 billion in revenue. So, these are actually quite sizable entities.

Judge: But they're also diverse, and one of the things that we have seen is that it's taking the Fed a lot more time to set up this facility. It's having to bring in banks to effectively partner with this facility, so the Fed is coming in and saying, "We'll buy up 95% of the loan, but we want the bank to hold on to the other 5%, and so we're trying to encourage banks to engage in good screening." But as we'll likely get to later, banks have different incentives. If you just put kind of these small and mid-size and really big corporations next to each other, you can see that just the need to engage in any kind of risk assessment in an incredibly short timeframe, given the fact that the Fed has very limited ability to do this institutionally, means that they are skewing their support to the larger corporations. And we know that the larger corporations are actually probably the ones that could go through reorganization if they didn't get funding and survive, whereas the smaller ones are the ones who potentially need the most support.

Judge: And in terms of the long-term health of the macro economy, that's oftentimes where we get a lot of the innovation and a lot of the new job growth. So again, it's not that the Fed I think is biased in any way, but its institutional skillset together with meaningful legal limits on what it's allowed to do under 13.3, and it skews where that funding is going.

Beckworth: So, the Fed's hands are tied by law, and by expertise, how much they can do. They're trying their best, and again, in the fog of war, Secretary Mnuchin, Fed Chair Powell, they were being aggressive, running fast as they can at the problem, but we've ended up with a mix as you outlined that is heavily weighted toward the Fed doing the lion's share of the action. And I'm wondering why did we end up this way? I mean, I have several ideas. I wanted to maybe hear what you think. But I mean, one would be it's just politically tough for Congress to do more spending. Second one is it's a way to hide the full size of the budget allocations that's needed. I mean, if we use the Federal Reserve, we're effectively going off balance sheets, so it doesn't count officially towards the public debt, even though it technically would use up the same fiscal space from an economic perspective.

Beckworth: But do you have any ideas why they ended up with this mix that relies heavily on the Fed more so than Congress?

Judge: Yeah. I think you hit on a couple of the points. I do think that at least one of the motivations had to be to reduce the appearance of the price tag, and this is something we've seen from Congress throughout time, right? I mean, so this is part of the reason we still have the Federal Home Loan Banks. We were trying to get out of the S&L crisis, and we wanted to meet deficit reduction targets, but we suddenly had to bail out a bunch of banks. So, what do we do? We have the Federal Home Loan Banks, that conveniently are off-balance-sheet, fund a significant portion.

Beckworth: Great point.

Judge: And it's something we've done often, so I think that was part of it. I do think actually the title of David Wessel's great book, “In Fed We Trust,” has resonated through my mind more than once during this period of time, as well. I think that there is this incredible challenge where there's a love-hate relationship really with technocracy in this country. We are deeply distrustful of these elite technocratic institutions at times. On the other hand, when we need really quick action, particularly if I dare say, at least among some people, with this administration. There's a distrust to just handing the blank check over to Treasury. And I think that's one of the real challenges that is coming through here, that Congress cannot legislate the level of detail that is required in the context of emergency legislation.

Judge: But the Fed I think is ill-suited for much of the role that it's currently been tasked to, so I think part of what we're really seeing is the need for technocrats that are broadly trusted, and that have a lot of credibility, and are seeing... They're trusted in part not to be overly favorable to friends of various sorts or corporate interests of various sorts. But I think it's been real drawbacks.

Should Relief Efforts Encourage Bankruptcy?

Judge: The third point that I think we hadn't really gotten to in much detail is one of the bright lines in the Fed's 13.3 lending authority is that they can't lend to insolvent institutions. And again, traditionally that made a lot of sense. If you have a financial institution that is near failure, we want to figure out how to force it into a resolution proceeding and we like to hope that after the last crisis, we created one that, knock on wood, will work if it has to. Whereas here, I think actually one of the things that we could do is to actually encourage companies to go through a bankruptcy process, and so this goes back to the shareholders and creditors versus the underlying enterprise.

Judge: I mean, from a long-term growth standpoint, we want to maintain those overall enterprises. We want to make sure that the infrastructure for creating those valuable goods and services, even if they're not currently in demand, that that infrastructure can come back to life whenever it is the economy manages to get back online, and we would like also to have money to continue to flow to employees, both to keep them alive and well and to also create demand for those goods and services when the economy is slowly inching its way back to life. So, there's a lot to be said for making sure the enterprise stays healthy.

Judge: But what's interesting for the large companies is we'd have to have some modifications to deal with the volume of cases. But chapter 11 reorganization actually works pretty well. So, you could allow a chapter 11 reorganization where the Fed could come in, or Treasury could come in and provide the financing that you need to be able to say like, "Current creditors, we're not going to let you destroy value. We instead want to make sure this enterprise stays alive and well. We're going to give the funding needed to allow it to do that." And then force the shareholders to take some losses, force the creditors to take haircuts as appropriate, and then allow the overall business to emerge on the far side of this as a healthier business. I mean, a well-run bankruptcy proceeding is meant to enable a business, the core business to survive, while allowing losses to be shared by the providers of capital. And really, the Fed, because it's again not allowed to do that, is instead injecting money into firms in their current form, and a lot of that I think is going to end up with some wealth transfers to institutions that had taken on a great deal of debt in recent years.

Beckworth: So, through no fault of its own, the Fed is actually doing the opposite of what you want it to do. It's actually channeling resources towards shareholders and creditors because the limits of its abilities by law and by expertise, and what you argue is it'd be better for these larger corporations to go through bankruptcy, come out the other side. It benefits the business itself and the employees. It's good for capitalism. We want healthy capitalism to emerge the other side of this crisis, and what we're doing is actually moving in the other direction. Is that fair?

Judge: I think that is fair. And it's funny, because I avoided using the term “bailout” for the last decade. I just find that such a loose term that I really disliked it. On the other hand, one of the challenges, again, I've spent the last 10 years immersed in bank regulation, and I learned firsthand how hard it is when we try to regulate how leveraged a company can be. And precisely because of the degree of government intervention that we are now seeing, we're seeing also a plethora of new calls to regulate leverage at all kinds of non-financial firms. And so, I think actually the long-term benefit... Again, I don't know if you could go just straight through a bankruptcy proceeding without any modifications, because I just don't know if the bankruptcy courts could handle this volume of cases. But the overall structure works pretty well, and you could imagine flushing out bankruptcy-like infrastructure pretty quickly that allows things like the automatic stay, which is what protects that underlying business, and where the government provides the financing to keep that underlying business alive. And at least in some of the circumstances requires some of those shareholders and creditors to take the losses that they agreed to bear and that actually over the last 10 years they've been incredibly well compensated in exchange for agreeing to bear.

Beckworth: That seems reasonable to me. Now, you bring up an interesting issue here, and this is the capacity of the courts to handle the volume of bankruptcies that this might require. And I think this has been an issue across the government, so from everything from the checks, the IRS has suddenly had to administer millions and millions and millions of checks during tax season, when they're already busy, to the SBA having to handle millions of dollars, billions of dollars worth of loans to many different entities. I mean, this crisis has thrown upon our government a huge increase in demand for capacity that simply wasn't there, and I think no matter where we go, whatever route we go, if it's more checks, if it's more bankruptcy, if it's more SBA funding, we're going to be frustrated to some extent simply because we don't have the people there, the infrastructure in place. It's going to take time to get up and running.

Beckworth: But I do think though with that said, we should still try, number one. And number two, and try something different. So, I like your idea of bankruptcy. Would you also throw in more funding with that, as well? So, maybe we do bankruptcy. Maybe do more funding through Paycheck Protection Program? Something along those lines?

Judge: I definitely would. Yeah. I think that's part of it. I think we have to recognize that the government is going to have to spend money right now, but it's spending money to invest in the future. I mean, really what we have to think about is not just current taxpayers, but the taxpayer base in the future, and making sure we have a healthy taxpayer base in the future, and sometimes that requires a current investment. And I think that that clearly is the case when it comes to the extreme tail events like we are currently facing, and so I think being honest that part of what we need is meaningful government spending and meaningful support for private enterprise is part of what we're going to have to do.

I think we have to recognize that the government is going to have to spend money right now, but it's spending money to invest in the future.

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Judge: And going back to your point about capacity, again, government funding can help build that bridge, which is a term that gets used a lot, and the question just is where that bridge is going and for whom are bridges being built.

Beckworth: Right. No, absolutely. But also your point that you make just now about we have to be honest that there's going to be a lot of funding, I think we should look at it through two different angles. We've touched on one of them already, and that is whether we use the Federal Reserve or not, we're still going to be incurring some bill. Just the Federal Reserve makes it look smaller. It's a way to keep it off balance sheet. It's a trick in public accounting. And so, we should be explicit about it and say, "Look, this is a huge undertaking. These are the dollar amounts. We're not going to try to put it off balance sheet." That's the first thing.

Beckworth: And the other thing I would note is that this is like fighting a war, and I've made this point here before. This is not your garden variety recession. This is not your garden variety debate between conservatives and liberals. We're fighting a war, and it's all hands on deck, and this war will take some investment. I like the way you framed it. Investing. We're investing in our country's future here, and we're investing in businesses and enterprises, but we got to be smart it. And I think your idea for bankruptcy is one way to do that. We want to make sure we have viable businesses and capitalism on the other side.

Beckworth: I guess one takeaway from reading your article, from sitting back and looking at what actually is happening both with the Fed, with the Paycheck Protection Program, the ongoing conversations, I really worry we're all going to be disappointed. I think we have these high expectations, the Federal Reserve, it's the Federal Reserve has this alphabet soup, 11, 12 facilities. I think we're going to be disappointed there, because the Fed's going to have a hard time going that last mile into small businesses, into states, and counties, and cities, and we're going to be disappointed. Congress is going to be disappointed. I think the Fed's going to be disappointed when it learns that it's become more politicized.

Beckworth: So, I know we need to be doing something. I just worry that we may have our hopes set too high. So, help me out here. Is there a case to be made for a good outcome? Or are we going to kind of just do average? What do you think?

Judge: I think we are going to be disappointed, and for me that is yet another reason that I would like to see more authority vested outside of the Federal Reserve. I mean, I think we saw at the very early stages of the crisis the Fed come in with just remarkable speed and creativity. And a lot of what they did initially, and even to this day, is quite consistent with what you generally want a central bank to do. So, they were incredibly aggressive with monetary policy, quantitative easing, which is in some ways monetary policy, but right now is really also about liquidity and liquidity in the Treasury space. And with all of the different short-term facilities.

Judge: This is where one of the things we realized last crisis is that if the financial system evolves, so it's not just a bank-based system, but you have a bank-based system of intermediation that operates alongside a market-based system of intermediation, then even doing the more traditional lender of last resort type activities is going to require doing not just a discount window, but creating other facilities to help support those short-term stable markets, or markets that we want to be relatively safe, but where fragility arises early on, and where if we allow that fragility to manifest in runs, then we get spillover effects that everybody wants to avoid.

Political Implications of Relief Effort Performance

Judge: And so, part of what I really am motivated by is I want to make sure that we continue to have an institution that is sufficiently powerful, even within our democratic system, that it can act quickly and it can act before Congress to take actions that were as dramatic and as helpful as the Fed took in the areas where we have a paradigm over what a central bank ought to be doing in terms of just supporting market functioning. So, one of the concerns, and I think you're right, I think we are going to be disappointed. I think everyone is going to be disappointed and I think there's going to be real frustrations. I think there's going to be real inequities, and I think we are already seeing that, and I think they're going to become even more apparent as time goes on. And I think one of the things we saw over the past decade is that as inequities grow and as they become more salient, popular frustration also grows and it leads to backlash.

Judge: And I think one of the things I found disconcerting is that right now, not only is the Fed doing this incredible work through 13.3, but we also see the chairman, Jay Powell, really as the face of a lot of the government's efforts, even though of course he's working closely with Treasury on all of these operations. And for me, from a political accountability perspective, that's disconcerting. When we're making these types of decisions, where you were necessarily helping some but not others, and where you're going to have some people who are disappointed and frustrated, you really want somebody who's closer to an elected official, like a member of the president's cabinet, to be the face of those initiatives and to feel an obligation to explain to the public what they are doing, and what you hope in a best case scenario is that filters up, and that the President then feels obliged, and this might be overly idealized today, but feels obliged to actually take some responsibility and explain even difficult things to the public at large.

Judge: Maybe think back to FDR. His very first fireside chat was about the bank closures. And he sat down, and he tried to speak directly to the American public about this decision that he was going to make, and he took full responsibility for the decision, and it was one that would and did scare the public, but he felt the need to communicate with them about it. And so, one of the reasons you oftentimes want elected officials to make the difficult decisions is precisely because they need to be reelected. Once they have to make those difficult decisions, they also feel the need to explain them. And so, one of the concerns with the Fed doing so much are not just the institutional and legal constraints, but really wanting to protect long-term its capacity to do all of the great work that it does and seeing fewer happy endings as those responsibilities continue to expand and morph.

One of the concerns with the Fed doing so much are not just the institutional and legal constraints, but really wanting to protect long-term its capacity to do all of the great work that it does...

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Beckworth: That's a great way of putting this. Jay Powell has become the face of many of the government's efforts to provide relief to the economy. I'd argue he might be as prominent or more prominent than the Secretary of the Treasury is, Steven Mnuchin. In fact, I saw a poll recently that the Fed's popularity is growing among people asked in the country, so just to confirm your point.

Beckworth: Also, though, I think what you raised about popular angst and anxiety about government is spot on, as well. We saw coming out of the last crisis how populism has arose from that mess. Now, I believe there were other things going on, globalization and all the problems it created that... I believe in globalization, but some of the collateral damage that it created on top of what happened in the Great Recession led to the surge in populism around the world. And you're right, if we're all disappointed and no one's happy with the outcome, we're going to see some more of that. So, I mean we already see people on the left criticizing what the Fed's doing. Senator Warren, for example. Congresswoman Waters. They're criticizing what firms, what conditions, but I believe we'll see the same critiques from the right, as well.

Beckworth: People on the right are going to be unhappy, as well. So, one of my fears is we're just going to fuel the existing divisions between the right and the left that already exist, and we're going to find the narratives to confirm our priors, our views, and we're not going to change much. One hope would be that this experience would bring us closer together as Americans, right? We rise to the occasion. We're fighting the war. But if we don't do a good job and if our hopes are not met, we might end up being further divided.

Judge: Yeah, I think that articulates it beautifully. And that is the real challenge, and nobody can expect anybody to do a perfect job. I mean, one of the real challenges is when you're having to act so quickly, you're going to make mistakes. So, there does need to be some room for forgiveness and understanding as mistakes are made, but when you're talking about structural issues, where a disproportionate amount of the aid perhaps is going to some more than others, then I think that does breed longer-term resentment. Or when those decisions have to be made but they're not adequately explained, then you get even greater resentment. And so, even though right now we're mired in this period of difficulty, where we're all just grateful that the Fed is doing anything, I do have some concerns, and well see how it evolves, that as the dust starts to settle there will be backlash on both the left and the right.

Judge: And the partisan issues that you allude to, which I think... I'm already dreading the confirmation hearings should it be anybody other than Powell who's being re-nominated.

Beckworth: No kidding. You know, it makes me wonder if Fed nominations are going to get as cantankerous and as... I won't say violent, but it makes me wonder if Fed nominations are going to be as challenging as Supreme Court nominations going forward, given the amount of debt, the amount of involvement, the size of the footprint of the Federal Reserve. So, this will be interesting to watch, for sure.

Beckworth: So, let me throw one idea at you, and it's along the lines you had, but I don't think it's exactly up your alley. But I want to hear your thoughts on this. There is a proposal for a debtor-in-possession financing facility from some individuals. Arvind Krishnamurthy is one of them from Stanford that I know, and the basic idea if I understand it correctly is that you allow these big organizations to go into bankruptcy, but you provide a special facility to provide them financing during this period, so you don't have creditors coming after them and causing problems for them, making life harder for them. But is there any merit to this idea? Would it complement your thinking or are you going in a different direction?

Judge: No, I think it's actually very much in line with my thinking as a policy matter.

Beckworth: Okay.

Judge: I think it's precisely the type of proposal that we need. So, as a general matter, one of the reasons bankruptcy works relatively well is that you're able to get interim funding for the company. So, you go to bankruptcy court, you file your petition, and then suddenly you're protected from efforts by your creditors to pick apart the company in ways that might destroy value, so there's an automatic stay that protects the company, and then you are able to get this fresh source of financing, this debt financing, because the party that's providing that financing is taking a senior, secured position in exchange for financing you through the bankruptcy process.

Judge: And one of the concerns that has been out there which I think is quite appropriate, is that under the current circumstances, it will be a lot harder for companies to get that debt financing. And it's even worse given the fact that nobody knows what the post-COVID economy actually looks like, so just because a firm was relatively well performing pre-COVID, might not be a perfect indicator of its long-term viability. And so, the idea is that if we want to make sure that we are really supporting the underlying enterprise and not creditors and shareholders, then bankruptcy provides a mechanism for protecting that underlying business, allowing employees to continue to get paid, while making sure that again, shareholders get wiped out if appropriate, and creditors take haircuts if appropriate, and then the new firm can emerge.

Judge: The big concern I have with something like that, so I think it's a great proposal as a policy matter. David Skeel and Ken Ayotte have proposed something similar. Really comes down to whether the Fed can do this right now consistent with its obligations under 13.3. And I've read some creative ideas out there if they are providing a facility that allows a financial institution to provide debt financing, as opposed to providing it directly, maybe they'd be able to do that. But again, one of the more clear limitations on the 13.3 authority is they're not actually supposed to lend to insolvent or bankrupt firms. Even though right now as a policy matter, that might be precisely who should get money.

Beckworth: Yeah, and that was my big question about this proposal. It sounds great on paper, but legally, what would it take? Would Congress have to rewrite the Federal Reserve Act, or would Congress just set up its own facility? I don't know. What do you think would be the easiest path forward if they wanted to go this route?

Judge: I think for me, this is yet another example of first of all, why people need to understand bankruptcy better. But also why you need more funds that are not tied to the Fed's 13.3 authority. I think rather than going in and trying to monkey with the limitations on that 13.3 authority, I think creating more accountability and saying, "Look, maybe debt financing is the right thing to do." Maybe you have to want an alternative, where you say, "We're going to extra incentives on companies to maintain their footprint, to maintain employees." There's all kinds of things you could do if the aim really is the long-term health of the enterprises and therefore the overall economy, and to do that we're going to need to provide more money to agencies that are closer to the executive, and provide other mechanisms of accountability.

Judge: And so again, I understand the faith in the Fed and the trust in the Fed, but I think rather than trying to figure out how we enable the Fed to create this type of facility, the better approach would be either for Congress to mandate this type of intervention, or to provide greater flexibility within appropriate confines and with appropriate oversight for this to be provided outside of Fed facilities.

The Fed's Lending Facilities: What Else Can it Do?

Beckworth: Okay. Well, let's move on to some of the Fed facilities specifically, and I won't go through all of them for the sake of time, but I do want to touch on some of the newer ones that are more controversial. So, I want to talk first about the Corporate Credit Facility, so there's a Primary Corporate Credit Facility, which in my view isn't that controversial. You have to be investment grade or you were investment grade before the crisis, you're a fallen angel, so that seems relatively understandable in terms of bridge financing, getting a liquidity facility, getting us through the crisis.

Beckworth: But the second category, which is Secondary Market Corporate Credit Facility, so this is where you go into the market and you buy bonds, and they also allow the Fed to buy... This facility empowers the Fed to buy ETFs, exchange trade funds, including high-yield or we would say junk bonds. So, you wouldn't actually be... I don't think they're going to be buying junk bonds directly. They're buying them through the ETFs. And this has raised some eyebrows. Now, the Fed hasn't actually got this facility up and running, but it has already moved markets. It's restored life to some extent in these markets. And I'm wondering if you have any thoughts. Did this facility concern you or is it a step in the right direction? Or how would you maybe improve it if you could?

Judge: Yeah. A couple thoughts there. So, it did concern me. As you pointed out, as soon as it was announced and as some of the details started to emerge, we saw an immediate change in yields on the companies whose debt might qualify, even though it is intermediated through the high-yield ATF structures. So, it's clear that the very announcement of these types of facilities is having effects, and again, those effects were disproportionate. It's benefiting the types of companies that might be able to benefit, and therefore changing overall access to financing across different types of entities in ways that might be disconcerting.

Judge: Second, one of the things that I have not seen in the term sheet, but is in the frequently asked questions that the Fed put out about the Secondary Corporate Credit Facility, Secondary Market Corporate Credit Facility, is that when it's willing to buy up these investments, which they say are going to be relatively limited, they will anticipate having an equity cushion from the Treasury of either somewhere in the range of three to one to seven to one. And they're going to make the determination at the time they actually make the acquisition.

Judge: And so, going back to my earlier conversation about the Fed, I was really ascribing to it in much of that conversation a good faith limitation in what it's doing arising out of institutional limitations and what it can do quickly. And the amount of risk it's really designed to take, given that adequately secured language in 13.3. But one challenge for the Fed, is once for any class of assets it's willing to say, "We're going to buy up assets that are so risky that we actually need the Treasury to take a 30% equity cushion, because we anticipate those types of losses." It opens itself up to a whole variety of questions.

Judge: Well, if you're willing to take on that kind of risk, then why aren't you doing more for all of the other small businesses, nonprofits, municipalities? And so, it's just... The shift to that type of, that size of equity cushion, I think just exposes it to a variety of questions later on about the other types of facilities that it's not setting up. And again, I think from a systemic stability standpoint, there might be reasons for it to be concerned. I mean, the traditional idea of course around ETFs is that actually they should be more stable than something like a bond fund, because a bond fund actually has built into it some incentive to run. And there's been great work done by AJ Goldstein and a bunch of other economists showing how those dynamics could actually encourage run-like behavior when you have a more traditional fund.

Judge: By contrast, with the ETFs there's the possibility of a discount if the arbitrage mechanism isn't working well. Precisely because you have that discount, you don't have the incentive to run. So, they actually should be more resilient in the face of current distress conditions. So, in short, I do have some concerns and I have some questions, and it will be interesting to see if and when the Fed actually intervenes into those markets, not just through signaling it's going to, but through actual acquisitions, if it's willing to say more about why it's willing to take such risk, buy such risky assets in this domain, and not do more in some other areas.

Beckworth: Yeah. The impression I get from the Federal Reserve, the impression I got from Fed Chair Jay Powell today, it's April 29th, in his press conference, is that they're pretty close to actually opening up the Corporate Credit Facilities and going in. So, we'll see pretty soon, but it goes back to what you said earlier. They're better equipped to deal with these big corporate entities. They can buy bonds because they got credit ratings. They can deal with big, well-developed markets and structures. Whereas with like the Main Street facility, where they're supposed to go into smaller businesses, he said today that this is still being thought out, it's still being developed, and made it sound like it's a long ways off. And I know they're doing their best to get there, and again, Congress is leaning heavy on them, but it's just hard for them to make sense of it all and to do it in a tractable way.

Beckworth: And going back to our earlier point, I think we're going to be disappointed. I mean, the Fed's going to be able probably to deal with these Corporate Credit Facilities. There'll be still questions we have about why and how. But your point about they're willing to risk all this capital on high-yield ETFs, yet they're dragging their feet when it comes to Main Street Facilities. And again, I'm not trying to impugn any motives or anything here, it's just it's hard for them to do it. This still looks like bad optics. It fuels popular resentment. And again, it's going to be an issue of disappointment here, and it jeopardizes the Fed's independence and credibility.

Judge: Yeah, and I think you summarized perfectly, and I do think the Main Street, the challenges they have faced in trying to set up the two different Main Street Facilities really bring this to life, and these are not small businesses. I mean, these are actually quite large businesses. They just don't yet have publicly-traded debt or debt that's been created by an investment agency. And it is also interesting, because then we're seeing the challenges that arise when the Fed has to work through the banking system, because it doesn't have its own capacity to evaluate credit risks, and banks are good at this in some ways, but they have imperfect incentives in other ways. And I think one of the real things to watch whenever these facilities do come online is of course here we also have to separate facilities, for new loans versus extensions of credit to situations where there's already a credit relationship.

Judge: And a bank that already has made a significant loan to a mid-size business is going to have a lot more incentive to make sure that that business has continuing access to cash flow in order to stay alive. And so, again, no ill intent by the Fed. Could be just the opposite, where they're really trying to reach the broadest swath of qualifying companies that you could imagine. The incentives, both in terms of the information banks already have, but also the economic incentives they have to make sure that loans already on their books are less likely to go into default really change the economics regarding extensions of credit that are to completely new clients versus providing a new loan to an existing client and then being able to pass 95% of that loan onto the Fed and in the process, effectively make it more likely, even though there are some limitations on what you can do with the funds, make it more likely that your existing loan to that client is going to be paid off.

Beckworth: Well, we saw that already with the Paycheck Protection Program. Through the SBA. Most of the loans that banks, and those are ultimately going to be grants, but they're loans initially. Through the SBA, through the PPP program, were given to existing clients, who they know, or they have existing business with, or they're large, or even if it's a first come, first serve, usually it's the biggest entities that get through the door first. So, I think we have evidence already this will probably be the case with the Main Street Facility.

Beckworth: And as you mentioned, these facilities themselves, which are targeted for Main Street, they still aren't well designed to hit the small businesses, so the requirements, 10,000 employees or less. Well, 10,000 employees, that's a lot. 2.5 billion revenue or less, that's pretty large. And you got to have at least a million dollar loan. There's probably a lot of small businesses who don't need a million dollar loan. I think again, I don't mean to beat this drum too much, but there's going to be a lot of disappointment and resentment when this is all said and done. And again, no fault of the Fed. Its hands are tied by law. And so, this is... Yeah, not looking great.

Beckworth: This is a very downer kind of conversation, Kate, we're having here.

Judge: I know. I wish it was otherwise. Actually, unfortunately I have an even more dour note to add to this. I mean, one of the issues that we've started to see already, and it's reflected in some of the recent market prices, is one of the things that I think the market's starting to anticipate is acquisition activity by some of the larger firms. And so, part of what we are seeing is if some firms have access to financing and others don't, the ability to buy those firms up at a relative discount, because they really have so few alternatives, could result in greater concentration. And so, it'll be interesting to see if that happens.

Judge: And again, I don't think a merger ban is the answer, because I don't think a company that is a small company otherwise is going to have to fail, and then infrastructure gets lost is optimal, but I do think there's some unintended consequences that might well arise as a result of just where we're able to get money when we're relying on the Fed to do it.

Beckworth: Yeah. All right, let's talk about the Municipal Liquidity Facility, which also hasn't opened up yet. That's going to be targeting counties with a population greater than 500,000, cities greater than 250,000. Those numbers were lowered from the original criteria. Up to three years in terms of a loan. And there's $500 billion there that the Fed wants to invest, but what's interesting in the new tweaks to this proposal is that any of these municipalities have to first have tried a bank, Wall Street, some other form of financing before they come to the Fed. So, on one hand the Fed has loosened the parameters, so that smaller cities and counties can get in. On the other hand, it's tightened it by saying, "Look, you better have tried somewhere else first before you come to us."

Beckworth: And I think that's actually smart, because again, the Fed, and the people who want to do a lot of things is going to be disappointed. This is one way to maybe curtail and manage those expectations.

Judge: Yeah. I think I agree with that. This is going to be one of the facilities to watch. One of the real challenges is after you had the CARES Act structured as it was, and naming states and smaller municipalities as appropriate targets for these funds, and you had the Fed doing so much else to support businesses, it would have been very difficult if not impossible for the Fed to create some facility along these lines.

Judge: On the other hand, this is very fraught territory, and they're working really hard right now to limit that in terms of the financial conditions that they're imposing, but this is another area where you can just imagine significantly greater political pressure being brought to bear. And again, part of the question is are we just kicking down the road problems that really are better addressed sooner rather than later, and being less than honest over the nature of the fiscal responsibility that the federal government has to support other levels of government during these extraordinary times.

Beckworth: Yep. Absolutely. And again, just to reiterate, we appreciate what the Fed is doing. The Fed's a great institution and we wish it well. But its hands are tied, and Congress really is asking it to do a lot, and that's going to create some unfortunate outcomes.

Beckworth: Well, with that our time is up. Our guest today has been Kate Judge. Kate, thanks so much for coming on the show.

Judge: Thank you so much. I really enjoyed our conversation.

Photo by Michael Judkins

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