Preferred stock will help big firms recover from Covid-19

THE good news from Washington is that, despite partisan divides, Congress and President Donald Trump have moved swiftly to enact the unprecedented Coronavirus Aid, Relief and Economic Security (Cares) Act in response to the Covid-19 crisis.

Yet it is becoming clearer by the day that these measures will not be sufficient, and lawmakers are already talking about the need for another stimulus package. We urge them to take a different approach to supporting large corporations in the next deal. Indeed, many of the options for helping large corporations are not founded on sound economic principles.

One economic remedy included in Cares is lending billions of dollars to distressed large companies. Such large-scale lending at low interest rates creates a dangerous catch-22: some corporations, many have argued, may use the loans for purposes unrelated to the current crisis, such as stock buybacks. Though the Cares Act prohibits that, imposing further regulations to restrict uses of these funds would be costly to implement and enforce.

It is also difficult for the government to determine, within a short time frame, which companies most deserve help. And government lending, of course, adds to corporate debt. Meeting obligations to repay that debt in the future may create liquidity problems and divert a corporation's cash away from payrolls, or more socially valuable expenditures, particularly in a period of recovery.

What this crisis requires is a solution that ensures funds go to the companies that actually need them, quickly and without unintended consequences. As Congress contemplates another trillion-dollar support package, policymakers should recognise the flaws of large-scale lending and consider an alternative: that the US government (either the Fed, the Treasury or another new entity) buy newly issued preferred stock of publicly traded corporations.

The preferred-stock solution has a number of strengths, chief among them its ability to get cash to corporations quickly, limiting what would otherwise be a flood of bankruptcies that the courts and the distressed finance sector simply cannot handle.

This approach also levels the playing field: When companies raise cash by issuing preferred stock, they can themselves adjust any future payments to preferred shares (either dividends or buybacks), according to available funds. Each corporation would face the same options; there would not be any special deals for cruise lines, hotels or other industries that can claim unique circumstances.

While government loans increase a company's leverage - and therefore limit potential future borrowing - an equity issue decreases a company's leverage, making it easier to secure further loans from other sources, avoiding a rise in future liquidity problems.

A KEY ELEMENT

Additionally, the preferred-stock route protects against concerns of government interference in the private sector. Because preferred stock does not carry any voting rights and has priority over equity, all management decisions remain in the hands of the voting shareholders. This means no government moral hazard and no nationalisation of businesses.

Making preferred-stock purchases a key element of the way forward could also help the US government reap massive profits down the road. That may sound like an optimistic view today, but we project a strong comeback for the US economy.

Many of the 2008-2009 bailouts had similar features. The AIG bailout, in particular, gave the government substantial equity participation in return for bailout money and generated a considerable amount of money for the government - US$22.7 billion by the US Treasury's count.

That leaves one important detail: the price. Typically, the market value of preferred shares is lower than the market value of common shares. Negotiating the appropriate discount for each company could lead to costly delays, especially given the ongoing market volatility. In our opinion, pricing the preferred stock at the same level as common stock would be a sensible and fair compromise.

Under Cares, businesses large and small across the economy will receive massive financial support from the federal government. As lawmakers ponder the possibility of a fourth-phase stimulus package, they should take time to craft a better solution for large listed companies - one that gives struggling businesses a much-needed cash injection without leaving them or the government tangled in a web of debts that may never be paid off.