Corona Crisis, Company Bankruptcies, and Financial Crisis
Many times, since the beginning of the current turmoil it was repeated that the current crisis is different from the Great Recession of 2008, because the economy entered this crisis in a much better shape. Therefore, we can expect economy to rebound as soon as we get rid of the bug. But was the economy really healthy? How healthy was it?
Good deal of arguments in this article are consistent with and have been drawn upon the article “The Credit Cycle Before And After The Market’s Awareness Of The Coronavirus Crisis In The U.S.”, Edward Altman, April 2nd, 2020.
The biggest driver of the Financial crisis of 2007–08 was the overwhelming amount of the accumulated debt in the economy. Where were we at the end of 2019? Global non-financial corporate debt reached 92% of world GDP in Q3 2019, rising from 72% in 2008. Figure 1 shows US non-financial corporate debt as % of GDP and how peaks of it have always been followed by peaks in corporate defaults. We were at the end of the 11-year credit expansion cycle, the longest in history, and the amount of the US corporate bonds reached $9 trillion, double from what it was in 2009. Again, we had a build-up in non-bank lending, which exploded to an estimated 42% of all commercial lending. In April 2020, Ed Altman (Altman, April 2020) writes: “In the first two months of 2020, new issues were at record levels!” and “A Debt Bubble was building almost without pause as of the end of 2019 and into the first two months of 2020!”.
High indebtedness doesn’t necessarily mean bad performance of the real economy, au contraire! — one could even say. The defaults on the debt, failures to repay, corporate bankruptcies — on the other hand do mean that. They mean people losing jobs, they destroy general public confidence, and subsequently consumption, drawing economies in deep recessions and depressions. The model is such that we don’t know how high levels of debt we can have, but we know we are going to be good for as long as we don’t have (a lot of) defaults.
How do we get from a high-indebtedness environment to a high-default-rates environment?
The answer is: through a recession! As depicted in Figure 2, every recession (yellow) in the last 50 years had default rates (blue) peaking at the end of the recession. Makes sense: companies that were able to service high interests and debt repayments during “good times” can quickly become unable to do so during the “bad times”. And that is catch-22! Recession, non-fundamental, triggered by Covid-19, triggers high levels of corporate defaults/bankruptcies, and those in turn trigger a long, deep, fundamental recession.
What could be different this time?
Debt is categorised in two main categories: Investment grade, and Speculative / High Yield / Junk grade. BBB rating is the lowest rating of investment grade, and everything below it is classified as junk grade. As we can see from Figure 3, BBB grade is the most popular at the end of 2019 in the US. 57% of all investment-grade debt is graded BBB, only one notch over junk. This percentage is about double of what it was in 2007. If large amount of BBB debt would be downgraded to junk, it would crowd-out possibility of firms in that (high yield) market to re-finance debt, causing widespread defaults.
If we look at BBB bond issuers’ fundamentals at the end of 2019: working capital, retained earnings, EBIT, leverage, asset turnover — through the lenses of Altman Z scores, the result (Altman, April 2020) is that 30% to 40% of US BBB bonds already then, before Covid-19, had the quality of BB or B issues, i.e. the quality of junk-grade instruments. The downgrades have already started and are picking up quickly: in the last weeks of March, $90 billion of debt has been downgraded to junk (source: Financial Times, April 7, 2020). In Euro denominated market, almost €120 billion has been downgraded in Q1–2020, and further almost €70 in first weeks of April (source: ING, April 23, 2020). The EUR data are not only downgrades to junk, but all downward movements. Central banks are trying to counter-act: it is expected that tomorrow, on April 30, ECB will expand collateral eligibility to junk bonds, in an attempt to give financing lifelines both to them, and to high yield they would potentially crowd-out. It remains to be seen how far reaching these measures will prove in capital markets.
Conclusion
Current, virus-induced crisis is a catalyst for a full-blown financial crisis with debt defaults in its centre. Current crisis will cause recession, which in turn will cause unprecedented level of corporate defaults spanning the rest of 2020 and much of 2021. These are expected to result in a lengthy and severe recession.
The amounts of absolute debt, and indebtedness levels in current economy, as well as a much lower quality of that debt in comparison to 2007, suggest that a downturn could be more severe than what it was in 2008. On the other side, all analyses are done based on previous experience and models of past events, and we now have levels of support from governments and central banks like never before. Therefore, it is hard to predict effects of the measures that are being put in place by the world governments onto the development of the current crisis. Some of the negative impact will be mitigated, but that doesn’t mean we still won’t see a record levels of corporate failures.