Here’s Why Adding Billions More to the Second Round of PPP Won’t Fix It

Why simply adding more money to the pot won’t end the problem of venture-backed startups and large corporations landing relief loans

Photo: Jim Watson/Getty Images

The Paycheck Protection Program (PPP)— a federal initiative to provide loans to small businesses that are forgivable if businesses retain or rehire their workers — has proven wildly popular, burning through an incredible $350 billion in funding in less than a month. It’s also left millions of small businesses unable to participate. To address the shortage, the Senate has rushed to approve an additional $310 billion in funding that may be signed into law this week. The scale of these outlays is staggering, amounting to over $2,700 per U.S. household to date, and rising above $5,000 per household if the new funding is passed.

While the new legislation is likely to rescue the program as is, it does so at an extreme fiscal expense. But with a few strategic changes, a redesigned PPP 2.0 could be more impactful — and cost-effective — by ensuring that funds are targeted directly toward firms that truly need the funding, and not to firms that could manage without it.

What went wrong the first time

The program, as it currently stands, provides two year loans to small businesses and nonprofits (typically defined as fewer than 500 employees), at a very low fixed interest rate of 1%. Enrolling firms are able to borrow up to 2.5 months of the firm’s payroll, net of salary exceeding $100,000 annually. But importantly, these “loans” can be completely forgiven as long as the firm uses at least 75% of the funds to maintain payroll expenses, and the rest is spent on other fixed costs such as mortgages, rent, and utilities.

The original sin of PPP 1.0 was its inability to set clear parameters for which small businesses qualified for its relief loans. While struggling businesses should be thrilled to receive such loans, the problem is that financially sound businesses are delighted to apply for and receive them as well. And under the current rules, there are few impediments to them doing so. The only formal requirement is that “current economic uncertainty makes the loan necessary to support your ongoing operations” — a vague criterion that could seemingly apply to any small business in this unprecedented economic environment.

With such generous benefits, and the absence of meaningful restrictions limiting access, applying for the PPP is a “no-brainer” for virtually every small business in the country, making it no surprise that the program has faced overwhelming demand — from venture-backed startups with over six months of runway to large restaurant chains like Shake Shack (the company has since returned its $10 million PPP loan, although it’s worth noting that food service businesses of any size can apply).

Although it sounds counterintuitive, the extremely generous terms of the existing PPP have actually harmed many firms in need of benefits, by forcing them to compete for funding with the entire U.S. small business sector.

These overly lax enrollment criteria — open to severely affected and largely unaffected firms alike — have led policymakers to a no-win situation. On the one hand, leaving the PPP underfunded means that many of the most affected firms will remain locked out of the program without receiving any assistance at all. On the other hand, directing vast additional resources to firms that may not need assistance diverts taxpayer dollars that could be used for other important aid programs, such as expanded unemployment insurance, or direct efforts to fight the virus like widespread testing.

Getting it right the second time around

Now that we’ve seen the problems with PPP 1.0, let’s think about how to fix them.

Loan forgiveness — the most expensive part of the program — should be directly conditioned on economic outcomes. Under the current program, the government has committed to forgive the full loan balance, even for firms that will end up able to meet their payroll costs without help. Instead, forgiveness should be linked to the firm’s ultimate performance. For example, loan forgiveness could have been capped as some fraction of the firm’s operating loss, or the decline in operating income from the previous year.

While such a provision would have likely cut the final taxpayer expense, this change by itself might not have eased the shortage of resources plaguing PPP 1.0. Even if the program featured no loan forgiveness whatsoever, it would still have been offering credit to small businesses at extremely generous terms. As a result, PPP loans would likely have been in high demand even for financially healthy firms, leaving the program unable to enroll all applicants, with many struggling firms left in the lurch.

In principle, the Small Business Administration (SBA) could have tried to direct funds to the hardest hit firms by being more selective in the application process — no easy feat. Firms affected by Covid-19 may be difficult to identify in advance, and a thorough screening process for millions of firms would congest and delay assistance at a critical moment. Moreover, asking the government to set criteria for which firms are deserving of aid and which are not may prove to be a political landmine that is perhaps best avoided altogether.

Instead, the simplest way to avoid the enrollment logjam without spending more than $600 billion is to design the program so that the firms in greatest need would self-select into it. In other words, the terms of the PPP could have been set so that the less affected or more financially sound firms would voluntarily choose not to participate. While policymakers might want to expand credit to these businesses, this should have been done through a separate program that does not jeopardize the viability of the PPP. Although it sounds counterintuitive, the extremely generous terms of the existing PPP have actually harmed many firms in need of benefits, by forcing them to compete for funding with the entire U.S. small business sector. A smart redesign of the program could thin out the herd of applicants, so that all demand could be met with a much smaller fiscal outlay.

What we need going forward is a streamlined program that directly targets the hardest hit firms by forgiving debt only to businesses that can demonstrate need, while using less favorable lending terms to thin out enrollment.

What would this look like in practice? A simple fix might be to increase the interest rate on PPP loans from a superlow 1% to an above-market rate of say, 10% or even 20%. At such a high rate, a PPP loan could still be a great deal for firms, but only if the expected gains from debt forgiveness exceed the extra interest costs associated with the loan. If debt forgiveness is linked to low or negative profits, we should see PPP loans taken up only by firms expecting severely adverse outcomes, while those faring better should choose to seek credit at lower market rates.

Such an arrangement is similar to the taxpayer taking an equity position in the firm — accepting losses on the downside, but collecting some gains on the upside — instead of the pure cash giveaway provided under the current system. Federal interventions with this flavor implemented during the last recession, such as the Troubled Asset Relief Program (TARP) and the auto industry bailout, proved highly efficient at returning taxpayer dollars. To avoid profiteering off of anxious small business owners during this difficult time, any net profit to the government could be returned to participating firms in the event that the economy performs better than expected.

What comes next?

With over 825,000 confirmed Covid-19 cases in the U.S., tens of millions more suddenly unemployed, and interest rates at historic lows, now is certainly not the time to shy away from dramatic action. At the same time, with the U.S. taking on debt at an incredible pace, and the ultimate length and depth of this crisis unknown, Congress needs to make sure that each dollar of relief spending is put toward its most effective use.

While the course of the PPP seems largely set for the moment, additional funding will not be a permanent fix. Despite the program’s vast spending, it has provided vulnerable firms with less than three months’ relief on their payrolls, meaning that new rounds of aid will be needed if Covid-19 flares up in the future. And unlike past relief packages of this scale, like the 2008 TARP, little if any of this money will ever be paid back. While the U.S. may be able to afford this one-time $600 billion outlay, this cannot become a recurring expense.

What we need going forward is a streamlined program that directly targets the hardest hit firms by forgiving debt only to businesses that can demonstrate need, while using less favorable lending terms to thin out enrollment. Although making benefits less generous may appear harsh, it could make the difference between relief effectively and efficiently reaching the most affected firms, and a status quo that hemorrhages taxpayer dollars while leaving many deserving small businesses locked out of aid entirely.

Assistant Professor of Finance at the MIT Sloan School of Management, researching links between finance and the macroeconomy.

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