Slow Burn

August 22, 2020

Bankruptcy during the pandemic seems to be rather modest to date. I have been watching and posting about some of the larger bankruptcies to highlight the stress in the marketplace. Professionals are suggesting things could be about to get a lot worse and this makes sense because the government support for individuals and businesses is slowly ending. When that support is removed massive numbers of businesses and individuals will face very tough times.

A proxy for this has happened before, in fact, it’s happening right now. In the energy industry, companies by the hundreds, borrowed, issued stock, formed companies and used all of that capital to find, pump and sell oil and natural gas. One unfortunate gentleman (Art Berman) spent the last decade warning people that the economics didn’t make sense. He was ridiculed, companies paid to harass him, he was laughed at. He was right.

An excessive amount of money (mostly debt) was funneled into businesses that were economically unproductive (the oil and gas wells) causing an oversupply and companies produced way, way too much oil at a price they couldn’t make money. All of that money is now gone. Note that the companies ‘appeared’ to make money, but companies used debt to make up for their losses on business activity (sound familiar? Read on.)

This week saw even more bankruptcies in the oil and gas space (Valaris, Chapparal) but some of the largest companies in the world have collapsed or nearly collapsed. Haliburton, Valaris, BJ Services, Noble Energy just to name a few have all collapsed as their debt fueled bubble collapses.

The time from the collapse in oil and gas prices to the ensuing bankruptcies has been about 8-24 months depending on how you count it and which sector, oil or gas (first bump down in July, 2018, second drop started in January of 2020). Similar results should be expected in the rest of the economy.

The problem with oversupply has been significant in many areas of the economy for many years, and as companies continue to borrow and build (with low rates, even for commercial lending, why not?), the current collapse in demand will force ever more companies into bankruptcy. The resulting hit to the economy will likely last longer than most assume as employment gets hit, priorities change and automation makes a new push into the workplace.

Currently individuals in the US and Canada are largely ‘protected’ by moratoriums, but things are starting to ‘open up’ again. The protection means that bankruptcies are down dramatically across the US (295,000 bankruptcies in the first half of the US in 2020 vs. 387,000 in the first half of 2019!). Bankruptcy courts may simply have been closed. But now that the protections are being removed, downsides are starting to reappear – landlords seeking to remove tenants has begun in parts of the US. This will be in the headlines for weeks and months to come.

Predicting how this will turn out is difficult, but for nearly four million US homeowners, the worries are significant. The chart below is from the American Bankruptcy Institute, and it shows how many US homeowners are in ‘active forebearance’. In simple terms, they can’t pay their mortgage. Interest is still accruing, balances are getting bigger, but they can’t make the payments.

Small businesses have already suffered. In May, just as the pandemic was getting started, it was estimated that 100,000 small businesses had closed forever. Many of those businesses have not yet filed for bankruptcy (and may not, if there is no significant debt). In fact business bankruptcy filings in the first half are, again, down substantially from last year. If you assume just five employees per business, that’s is 500,000 of the ‘continuing claims’ for unemployment visible on the chart below (the total number is 14.8 million people).

Continuing Claims are still 2x higher than the worst of the Great Recession

While it may seem like a small issue, it isn’t. While this is happening, funding to these small businesses is drying up while large organizations have better access to capital (in the consumer space, there is a similar group, referred to as ‘the unbanked’, those who are not worth the time or risk for bankers/lenders). It is likely that many individuals and businesses will fall further down the economic ladder in the coming months.

Of course government is saying all of the right things but as Ronald Reagan once said, “The nine most terrifying words in the English language are: “I’m from the Government and I’m here to help”.

It is unlikely that Government can save the economy this time. After the tech bubble in 2000, the US Federal debt as a percentage of GDP was around 55%. Before the great recession it was around 65%. Before COVID it was 100% and now its about 110%. The amount of money required to support the economy is massive.

In the last six months, the US economy has soaked up about $4 Trillion of ‘aid’ but that was largely unproductive capital. It didn’t build a new power grid or a great national highway system or pay for a new healthcare system for America. It went to covering up the losses of money losing corporations and putting food on the table for the working poor. The wealthy also got money that was saved or used to reduce debt, but it was largely ‘unproductive’ in the economic sense.

When Ronald Reagan made his comment, the US government debt was $1T (~30% of GDP). Today it is over $23T (about 110% of GDP). Corporate profits have shrunk, certainly those companies that are no longer in business won’t be contributing to the economy. The vast increase in unemployed individuals will require trillions more just to keep families afloat and the money will likely prove to be hard to find.

The difficulty coming is a political one. The debt burden is carried by all citizens, but the money has gone disproportionately to a very narrow group of recipients and when those who are not receiving enough support become agitated, the outcome tends to be social and likely result in unrest.

When societies work collectively that energy can transform communities, nations. In essence that is how America and many other countries were formed. However the divisiveness of politics in the US particularly, the growing ‘class’ divides, the attempts to demonize others based on racial, religious or other lines is increasing. If this continues and economic catastrophe strikes, those divisions will seed ever more unrest until a collective consciousness overwhelms the differences.

The problems, including bankruptcies, are on a slow burn, but the problem hasn’t disappeared. Markets seem to be ignoring these risks despite rising economic uncertainty. The next move in markets could be another fast one. Probabilities are that it won’t be a fast move up.

[Recent notable bankruptcies in Canada: TLC Vision, Moores, Stokes, Tristan, Mendochino]

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