Of all of the market cycles that we have been through over the last 40 years, the looming fallout from the current Covid-19 pandemic may create financial hardship that could reverberate for a generation. The US economy generates roughly $50 billion of commerce every day ($19T GDP / 365). The almost immediate shutdown of all but essential food, healthcare and government activities will have an immediate effect across the population.
With over 30,000,000 small business and roughly half of the US labor force working for small businesses, the next few months could have a dramatic impact on tens of millions of households and lives. The overall economy is so heavily based on consumer activity that if more than half of the workforce experience a significant disruption in income, the “trickle up” effect will have a far reaching impact.
During each recession there are new ideas that have been instituted to help with recovery; The Resolution Trust Corp, The Financial Stimulus Program, Tax policy changes and one unofficial strategy that might have application for the current situation. From 2008-2012 many lenders and borrowers engaged in a practice referred to as “extend and pretend”. The situation applied to commercial property loans that were significantly under water, but rather than foreclose or call a loan forcing a bankruptcy filing by the borrower, the parties agreed on various ways to extend the loan, reduce mortgage payments and provide time for recovery of value and stabilization of the asset.
As we contemplate “what comes next” in these first few days of seclusion, it is not difficult to envision what could happen if the effects of the pandemic force a prolonged period of isolation. The businesses that are tenants in most commercial properties will experience a reduction or total loss of revenue. For most of these businesses, after labor costs, the building rent or mortgage payments represent between 20% and 50% of their fixed costs. If there is a prolonged (i.e. more than a couple of months) period of lost revenue, the businesses will likely close and there would be a default on the lease and/or mortgage.
More concerning, as companies begin to lay off employees and unemployment spikes, individuals and families will struggle to pay mortgages or rent, and this could exacerbate an already dreadful homeless situation. This outcome would put additional strain on already stretched government resources.
If Tenants are unable to pay rent, Landlords could run into issues paying debt service and will likely go into actual or technical default of the their mortgages. Lenders will then be faced with the decisions of issuing notice of default and beginning foreclosure procedures, which will likely lead to more bankruptcy filings.
All of this is a pretty gloomy outlook of how the dominos would likely fall. But within the recent rate cut by the Federal Reserve, we may have the seeds of a plan to forestall the immediate destruction of the economy. The reduction of the Fed Funds Rate to 0.25%, along with the strict reserve requirements instituted after 2008, has put the country on strong liquidity footing, at least at the banking level. Even with the recent stock market correction, there is still plenty of capital in the US and in the world. If we are able to take a longer term view, and borrow the concepts of “extend and pretend” we may be able to guide our way through a short term catastrophe. We just need “patient capital” to lead the way.
The basis of the idea hinges on the actions of the three L’s: Lenders, Landlords and Lawyers. The essence of the plan would be to create a three month full or partial freeze on mortgage and rent payments, and for a standing down of any legal actions to enforce default remedies during this period.
Here’s how it will work:
As the holders of all debt, Lenders would provide a 3 month “payment holiday” for all commercial and residential mortgages and credit card debt. The principal balance would be frozen, and the term of the loan would be extended by the number of months of the holiday. If required, the Lender could accrue or collect interest only during the holiday period at their cost of funds plus a reasonable margin (2%-3%?). The suggestion that this be extended not only to mortgages but to credit card debt is to protect the most vulnerable population to lost wages from becoming insolvent as interest accrues at rates above 20% when the lender is getting free money from the government.
For both business and residential tenants, the same 3 month rent holiday would apply. Tenants would still need to pay operating expenses and utilities to keep those services running. As with the mortgages, the term of any lease would be extended for the number of months of the rent holiday. The relief from paying mortgages would provide Landlords the protection from default and their loss would be in the form of return on equity. However, this would need to be balanced by the fact that if Tenant’s default or go bankrupt, there would be significantly higher costs to evict and there likely will not be a line of potential tenants waiting to occupy the space. With relief from the lender, and tenants still paying operating expenses, the deferral of a return on equity for a few months would seem to be a good trade off.
In times of economic upheaval, the legal battle lines get drawn pretty quickly. From bankruptcy filings to foreclosures and evictions, it can get pretty ugly in a short period of time. The suggestion of this plan is that we utilize our great legal minds to figure out the details in how to document these agreements rather than rushing into the courts to start prolonged and expensive legal battles. Along with the debt and rent holidays, there could be a three month moratorium on enforcement activities related to any defaults by tenants or borrowers.
As with most ideas, the “devil is in the details” and there will likely be plenty of unique cases that do not fit such a simplistic approach. However, in a time of global uncertainty, the basic human needs of food and shelter security, while we tend to those most impacted by the virus, are critical. The underlying economics for each family and individual will dictate how we cope with the next few months. In a time of great liquidity and zero interest rates, the idea of extending the game seems like a great way to buffer against economic Armageddon.
This likely needs to start from a higher place than one person’s idea, but utilizing our network of colleagues and friends, it might be an idea that is worth investigating. Would love to hear any feedback on your thoughts or other ideas.
Lou Battagliese is a partner at Jackson Cross Partners.