WHAT WAS IT WE JUST SAID ABOUT LARGE DEFICITS, INEQUALITY ... AND REVOLUTIONS?
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Over the past three decades, Kim Peacock and her husband Don Milroy built up a modest but respectable nut business based in Arlington, Texas. In March, 31 years of toil nearly unravelled in a matter of weeks.
The producer and retailer’s biggest customer was American Airlines’ Fort Worth hub. Every year GNS Foods supplied the carrier with millions of pounds’ worth of roasted pecans, pistachios, cashews and almonds. But when the Covid-19 pandemic grounded swaths of the airline industry, its wholesale business evaporated almost overnight.
“You think, how can I fight this? How can I survive? What can we do to make this work? Ms Peacock says. “And you just dust yourself off and get a second breath and go back at it. The last thing you want to do is let your life’s work go down the tubes.”
To survive, GNS quickly polished its website and set up a retail outlet in its Arlington factory, to sell over 100,000 bags of suddenly surplus nuts originally destined for American Airlines. The pivot has helped the small company stay afloat, albeit without Ms Peacock and Mr Milroy taking any salary and supporting themselves with savings. However, GNS is not out of the woods, and its struggles highlight the challenges faced by many US small businesses in 2020, with traditional sources of corporate funding shrivelling and the immediate burst of state aid now receding.
Efforts to refinance a $500,000 mortgage on its Arlington warehouse proved arduous. Although GNS kept making its loan payments, initially routine conversations with its bank Wells Fargo went nowhere after the pandemic struck. It was only in late November — a full 10 months after talks had first begun — that the mortgage was finally refinanced. “It’s as if they were looking for a reason not to give us a loan,” says Ms Peacock.
Not every US business is suffering from a credit shortage. Even as GNS was struggling to refinance its modest mortgage, its erstwhile customer American Airlines successfully tapped the bond market for $2.5bn this summer, despite burning through an estimated $58m a day at the time.
It came at a steep price, but helped the airline stave off bankruptcy for a few more months. That even American — one of the most indebted, stricken members of an industry that was shredded by the pandemic — could issue bonds at all is largely thanks to the power of the extraordinary stimulus unleashed by the Federal Reserve since March.
But the central bank’s largesse has failed to trickle down to a large part of corporate America, with smaller businesses suffering the worst credit crunch since the financial crisis.
The incoming Biden administration has many tasks in its inbox. But addressing the unequal access to corporate credit may be one of the most pressing. Failing to do so might mean that coronavirus will leave economic wounds that could take years to heal, analysts warn.
“This is the Achilles heel of the recovery,” says Gregory Peters, a fund manager at PGIM Fixed Income. “Smaller and medium-sized businesses that don't have access to capital markets are struggling mightily. They’re really hanging on for dear life, and the longer this persists, the more challenged they are. At this point, they’re being left behind. Inequality is a theme in all aspects of life these days.”
The widening gulf between the credit haves and have-nots is a longstanding trend in the US, as the bond market has become increasingly important as a source of funding and the banking industry has gradually retrenched.
Bigger companies also have access to more collateral to offer lenders — American backed its summer bond sale with some of its juiciest routes and gates — and can offer the prospect of juicy investment banking commissions. Yet unequal access to credit has become particularly clear since March, when loan and bond markets bifurcated dramatically.
In addition to buying trillions of dollars worth of Treasuries, the US central bank even started acquiring corporate bonds for the first time. Although modest in scale, the signalling effect of the Fed crossing this Rubicon has been a boon to any company big enough to tap the bond market.
As a result, corporate bond yields have tumbled back to the lows seen in the pre-pandemic era and nurtured a remarkable borrowing spree. US companies have sold $2.4tn of bonds so far this year, smashing records, according to Dealogic. However, most American companies are too small to even contemplate issuing bonds, which typically need to be at least $200m in size.
The government’s $525bn emergency “pay cheque Protection Program” offered vital succour to many smaller companies earlier this year, and helps explain why corporate bankruptcies have been surprisingly muted. But the programme ended in the summer. Meanwhile, the Fed’s separate “Main Street Lending Program” has struggled for traction, and may be killed off by the exiting Trump administration’s plans to withdraw the money that backstops it.
Many smaller companies therefore have to appeal to commercial banks for credit to help them survive until the economy fully recovers. That is proving tough.
The Fed’s surveys of loan officers indicate that banks continue to tighten conditions on corporate loans. Although the latest survey from October was not quite as grim as the one from July — when the negative reading was the worst since the financial crisis — it showed credit conditions worsening for a third consecutive quarter. Huw van Steenis of UBS notes that excluding PPP-arranged loans, US bank lending to companies has contracted at the sharpest rate since 2008-09.
Gabriel Chodorow-Reich of Harvard, Olivier Darmouni of Columbia University, and the Fed’s Stephan Luck, Matthew Plosser and Harry Cooperman recently pored through the details of the $555bn that US companies borrowed between February and June — using granular loan data reported by US banks to the central bank — and the results were telling.
The jump in corporate lending was almost entirely accounted for by big companies drawing down pre-existing credit lines, while smaller and midsized ones actually saw reduced use of credit lines in the second quarter.
The researchers point out that it is understandable that smaller businesses get poorer access to credit, given the paucity of timely, comprehensive and reliable financial information available to lenders, while big companies are regularly audited, often graded by rating agencies and — if listed — continuously scrutinised by thousands of fund managers and financial analysts.
Nonetheless, the Covid-19 economic shock allowed them to explore just how divergent the access to credit has become, not just in volume but in how onerous the conditions are. “The terms for smaller firms are much more constraining, the maturities of the loans are shorter, the loans more likely require collateral, the interest rates are higher, and the covenants are more binding,” Mr Plosser says.
The implications are considerable, Mr Luck notes. “The data points to smaller firms undergoing a credit crunch, while bigger firms are not. Down the road, that has implications for who is able to survive,” he says.
This is not just a US phenomenon. The Bank for International Settlements has found that companies with revenues of $1bn or more accounted for 70 per cent of all borrowing from the corporate bond and syndicated loan markets between January and June, close to the highest in a decade. This was unlikely to have been driven by their greater financial strength, as the creditworthiness of these bigger companies was only “marginally” better than midsized companies in the study, the BIS notes.
However, the bifurcated access to credit — between bigger companies that can access the fixed income market and smaller companies that have to rely on banks — is particularly acute in the US, where bonds made up a far bigger proportion of overall lending.
The shrinking physical footprint of commercial banks is a good example of how the business lending market has become tougher. The number of US bank branches per 100,000 people peaked at almost 36 in 2009 and has since shrunk about 31 in 2017, according to data from the St Louis Fed. Personal banking has migrated online, but small business lending still often requires local, physical roots.
Meanwhile, the heft needed to tap fixed-income markets is increasing. The average size of corporate bonds issued in the US reached a record $1.1bn this year, twice that in 2007. In Europe the average issuance size has also hit a record, but remains at just $593m, according to Dealogic, a data provider.
The difference between American Airlines’ bond market success and GNS’ struggles with Wells Fargo is a vivid example of the divergence. “It’s been better to be a big company than a good company in this market, and American Airlines is the posterchild of this,” says Victor Khosla, head of Strategic Value Partners, an investment group that specialises in the debt of struggling companies.
One potential solution lies in the rapidly-expanding “private credit” industry, funds run by investment groups such as Blackstone, BlackRock and Apollo to bypass banks and lend directly to companies. This is now close to a $1tn industry, according to analyst estimates. Although it is nursing losses at the moment, the richer opportunities thrown up by the coronavirus crisis means that there has been a boom in fundraising.
However, some industry insiders say private credit funds are increasingly focused on bigger companies. Given their expanding size, and the fact that the due diligence needed on a $50m loan is not much easier than that for a $200m loan, many private credit funds are naturally focusing their efforts on larger companies.
Moreover, the industry is overwhelmingly set up to fund companies owned by private equity firms. This means that most of corporate America have little hope of tapping them. “For businesses without private equity support it’s a challenge to find a financing source,” says Randy Schwimmer, head of origination and capital markets at direct lender Churchill Asset Management.
Nor has the Federal Reserve’s Main Street programme — an innovative effort to deploy the central bank’s firepower, in conjunction with the US Treasury, to help tide smaller companies over the coronavirus crisis — proved to be much help.
Despite revisions since its launch in June, most recently lowering the minimum loan size to $100,000 from the initial $1m, the take-up was dismal even before outgoing Treasury secretary Steven Mnuchin decided to withdraw by the end of 2020 the $75bn that the department had handed the Fed to insulate it against losses. As of November 5, only $4.9bn of the $600bn originally on offer had been lent, Goldman Sachs says.
“While scarring effects on the business sector remain surprisingly limited so far, the quickly deteriorating virus situation raises the risk that small businesses may struggle in coming months without further support,” the investment bank warned in a recent report.
Moving with urgency
Mr Mnuchin has proposed a new stimulus package with more support for small businesses, and the incoming Biden administration could look to restart or overhaul the Main Street programme in some way. At her formal nomination as Mr Biden’s Treasury secretary, former Fed chair Janet Yellen said aggressive action was needed to address “an American tragedy”.
“Lost lives, lost jobs, small businesses struggling to stay alive are closed for good,” she noted. “And it is essential we move with urgency. Inaction will produce a self-reinforcing downturn causing yet more devastation.”
Goldman Sachs recently studied similar small business support schemes, and advocates that the incoming government explore a loan guarantee programme akin to those in Germany, France or Denmark as a “middle ground” between the expensive, grant-like PPP and the cost-efficient but less effective MSLP. Done well, this could encourage banks to provide more of a financial bridge to struggling companies and ensure that they survive until the economy is in better shape.
Nonetheless, something more durable may be necessary to help ensure that smaller US companies continue to enjoy access to credit even when the pandemic fades away, says Peter Atwater, an adjunct lecturer in the economics department at William & Mary university and a former JPMorgan banker. “We’ve created a caste system for credit,” he says. “It’s significant, because its basis is entirely a function of size, not quality.”
Wells Fargo declined to comment on the problems faced by GNS in refinancing its loan, but said in a statement that it was striving “to make every responsible loan we can” to small businesses. “This year has been extremely hard for small businesses and we at Wells Fargo are doing all we can to help our customers keep their doors open, their employees at work and meet their customers’ needs safely,” it said.
Although GNS eventually managed to cajole Wells Fargo into refinancing its mortgage, Mr Milroy, the chief financial officer, is now fretting about the company’s credit line, which is due for renewal early next year. He argues that the willingness of banks to finance smaller companies has been noticeably declining for a long time, and especially in the wake of the 2008 financial crisis.
“It’s gotten harder every year we’ve been in business,” says Mr Milroy.