Visible Hands: Next Chapter, Please 🏦💸
Bankruptcy’s a lagging indicator of financial distress. Let’s understand it better.
Welcome to the first episode of Name...That...Debt!!!! First up: Name the companies that match these debt levels.
A) $18.75 billion. B) $1.65 billion. C) $4.2 billion. D) $7.3 billion.
Incredible, we can’t believe you guessed correctly that that’s: A) Hertz, B) J. Crew, C) JCPenney, D) Avianca.
Let’s just be clear, that’s a lot of debt. Take Hertz (hey Carl), whose revenue in 2019 was $9.8 billion and had about the same in expenses. Their debt’s double that. To contextualize, if their debt was translated into people, it would be 57 times bigger than the US population.
Unfortunately, these four companies have either said they may file for bankruptcy or have already done so. Those things -- their debt and their bankruptcies -- are not just coincidentally connected.
Chapter 11 bankruptcy is a process that allows companies with lots of debt to make a plan to repay their lenders without having to go out of business. Chapter 7 on the other hand sells everything off, paying back the creditors with the “profits”.
According to Epiq Global, corporate Chapter 11 filings have increased 26% from a year earlier to 560 filings. The thing is, we’re likely still in the early days of bankruptcy filings. Bankruptcy is like your friend who always comes late to a terrible, awful party. It’s a lagging indicator of financial distress -- unemployment tends to move in the same direction of bankruptcies and we’ve all seen the off-the-charts unemployment numbers. In 2009, there were 13,700 bankruptcies (~1,150 per month).
It’s a really bad time to go through bankruptcy given all of the uncertainty. Bankruptcy can often come at the cost of having to borrow more to get out of it. For instance, Neiman Marcus just got a $675 million bankruptcy loan approved, with expectations they’ll lose $300 million before stores can reopen. The cost of debt has whipsawed up (see Airbnb) and for stores that need to close, liquidation sales will likely be less successful with stores shuttered.
The incentives in the U.S. tax system (interest on debt reduces companies’ taxes) encourage companies to take on more and more debt. But with increased debt comes increased risk and payments that have to be made regularly, which is totally fine if companies prudently manage their financials and don’t encounter shocks. The beneficiaries in these situations are often the investors who swooped in hoping for a turnaround situation, so the heavy discounts they got on the distressed debt reap hefty returns.
It begs the question: do American companies have a debt problem? According to CNBC, American non-financial corporate debt totaled $6.6 trillion at the end of 2019. That’s a 78% increase since mid-2009. And the Fed is taking a portion of its leveraged lending program ($750 billion) and buying corporate debt with it, an unprecedented action that just kicked off this Tuesday.
While Coronavirus was the final nail in the coffin, it’s only magnifying a problem that was already in the works and sheds light on what happens when risky bets are made. Back in October 2019, the IMF warned that almost 40% of the corporate debt in major economies was at risk of default in the event of another global economic downturn. Go figure.
As an investor:
Be careful when investing in companies that have extremely debt-focused activist investors (I C U Carl) or vulture funds. You can see what Icahn and others are hunting on WhaleWisdom.
One worrisome industry to watch is oil. According to Moody’s, North American oil exploration and production companies are $86 billion in debt with maturities between 2020 and 2024. Pipeline companies have $123 billion in debt (same timeline).
Need another reason to rethink traditional investment schemes? Revisit the case study of Toys “R” Us, a victim of a dying industry, excess debt, and private equity pressures.
As an employee:
If your company filed for bankruptcy or is on the verge, know that except for secured creditors, people who are owed wages / salaries are given a higher priority for repayment. More info here.
If you receive equity compensation, remember that lenders get paid before equity holders. If you work at a public company, when was the last time you checked your company’s balance sheet?
As a consumer:
What about your old J.Crew gift cards? There will likely be a deadline to redeem gift cards, and if you miss it, any claims will be processed behind the company’s major creditors. Your credit card company may be able to help recover forgone money, but that’s rolling the dice.
As a citizen:
Push for better credit ratings than the ones we currently have. Auditors like Moody’s have previously admitted to a keen interest in propping up the ratings of the companies they evaluate. Although credit rating agencies have faced more scrutiny after the financial crisis, strong federal watchdogs are important. Check out the Director of the Office of Credit Ratings’ speech from February here.
Over 100,000 small businesses have closed forever as America's pandemic toll escalates: “Already, economists project that more than 100,000 small businesses have shut permanently since the pandemic escalated in March, according to a study...Their latest data suggests at least 2 percent of small businesses are gone.”
Buy America order could worsen medical supply shortages, economists say: “White House trade adviser Peter Navarro has been talking about it for weeks now — an executive order that would require government agencies to only buy U.S.-made medical products”
America's economy could get worse when unemployment insurance expires: “Even if the great reopening goes very well, at least some sectors of the economy ... are going to remain significantly depressed for a while. Workers who don’t get rehired by August 1 are set to see their bonus UI vanish and will need to start significantly curtailing their spending.”
Manhattan faces a reckoning if working from home becomes the norm: “[W]hen the dust settles, New York City could face a real estate reckoning.”
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