By Dillon Zwick
How do you account for panic in a financial model? What do you do when no one can forecast the future with certainty or accuracy? Economic forecasts have never been as divergent as they are now. The major financial institutions project Q2 GDP to range from -9% to -50%.
The maps we create during times of stability are helpful for understanding the world and charting a course of action. But during times of great uncertainty, those maps can become useless and we need other ways to navigate the world around us. We need a new kind of compass to tell us if we are heading in the right direction, and waypoints to anchor ourselves along the way.
Are we heading north or south? Are we on the road to recovery or ruin?
Current Phase: The Great Pause
A combination of monetary, fiscal, and regulatory interventions have paused the US economy. Between PPP loans, regulatory relief for banks, freezes on evictions, and mandated lockdowns, the US economy has gone into stasis for the next 60-90 days.
First Wave of Distress
The first wave of defaults have been cash flow businesses, particularly those related to the restaurant, travel, consumer goods, transportation industries, and energy companies. Chapter 11 filings are now back to 2011 levels.
The CARES Act provided the Paycheck Protection Program (PPP) loan program which ran out of money in 13 days, leaving many struggling businesses without the cash they need to survive. The second round of PPP funding is also expected to run out. 42.6 million people or about 25% of Americans have applied for unemployment benefits, more than 10 times what the system has ever handled. Constraints on state unemployment systems have left about half of those applying without benefits, many of whom haven’t had work in over 2 months.These delays exacerbate the crisis because according to BankRates 2019 economic security survey 70% of Americans have less than $1,000 in savings, with 45% having zero savings. Lack of cash is leading to delinquencies in car, rent, and mortgage payments. Demand for assistance from food banks has more than doubled across the country.
Eventually, the support provided by the PPP loans will run out, temporary regulatory relief measures will return to normal, evictions will resume, and the lockdowns will be lifted. People will transition from wait and see into the new normal.
A Gallup poll released on 4/14/2020 showed that 80% of Americans would wait to resume normal activities after the government lifts restrictions and allows schools and businesses to reopen. In Wuhan, China even as restrictions are lifted, restaurants are closing as people opt for box lunches because they fear eating out will cause infections. Iran began its phased reopening last week. As businesses reopened, very few shoppers actually showed up.
Second Wave of Distress
Highly leveraged companies and those with a 12 month tail in covenant agreements will start to go bust. While banks will attempt to amend and extend as many loans as possible, a large tranche will not exist in the same form they are today.
The US market accounts for about half of the $20 Trillion global corporate debt market. As of April 10th, 30% of US corporate debt is trading at distressed levels and at risk of default. The four largest banks have set aside a combined $18 Billion for expected loan defaults for the second quarter. While JP Morgan forecasts junk bond defaults to reach 8% by year end, far exceeding defaults in 2008.
In March, US credit card debt fell by the largest percentage in 30 years and consumer spending dropped 20% as consumers switched from spending to saving. Consumers have already been furloughed, lost their jobs, or are fearful they will be laid off. This trend will continue and further depress the economy as consumer spending accounts for 66% of US GDP.
Third Wave of Distress
The credit cycle is defined by a series of cascading events. First, there are positive feedback loops of borrowing money to generate higher returns, which increase asset values, which in turn allows for more borrowing, which leads to substantial economic growth and bubble formation. These are followed by a series of negative feedback loops, diminishing revenues which lead to spending cuts, which cause layoffs and defaults, which lead to more revenue loss. After the toppling of bad overleveraged loans, the next to fall will be the companies that were doing okay during the peak, but are now dragged down by the economic environment.
Bank of America predicts the bulk of new defaults will be “a 2021 story” as Goldman Sachs is predicting a 33% decline in cash spending by companies.
Fourth Wave of Distress
The hope that spurred survival from the first three waves of defaults will come to bear here. Loans that were kicked down the road through forbearance or amend and extend agreements will now come due. Any company that fails to adapt to the new way of business will also have its day of reckoning. This is the long tail of the recession.
There is a theory that recessions are a lot like forest fires. When you have them often, they clear out the deadwood and brush. They are relatively small, and considered healthy for the ecosystem the bounces back quickly. However, modern fire suppression efforts have caused deadwood to build up and up. So, in the rare times a fire does occur, it becomes devastating and takes much longer to recover.
On top of those waves of defaults, we must contend with the bubbles that formed during the expansion period. While it is harder to predict when these will go bust or how bad it will be when they do, we know the recession won’t be over until these stacks of deadwood are consumed.
A majority of Americans are considered to be better off since the last financial crisis, but 40% have fallen further into debt. Consumer Debt is now a historic $14 trillion dollar industry. Exceeding the peak in 2008 by ~2 trillion. That breaks down to 10 trillion in mortgage debt, 1.5 trillion in auto debt, 1.5 trillion in student loans, and 1 trillion in credit card debt.
The expanded unemployment rate now sits at 27%.
As of the end of May, mortgage loans in forbearance jumped to 9%, accounting for 4.75 million homeowners. Ginnie Mae loans are now close to 11% in forbearance. The national delinquency rate doubled to 6.45%, with serious delinquent mortgages (90+ days) increasing 14% in April. According to Tomasz Piskorski, an economist at Columbia Business School, if unemployment rates reach 30%, then 1/3rd of mortgages would go into default, causing 1.5 times as many foreclosures as the housing bubble collapse of 2008.
Ally Financial reports that 25% of its auto loan customers have applied for its payment deferral program. The NY Fed survey found the perceived probability of missing minimal credit card debt payments over the next 3 months increased to 16.2% in April. Capital One has enrolled 1% of it’s 120 million credit card accounts into a payment deferral program. While Discover, American Express, JP Morgan, and Capital One have allocated billions to potential credit card loan losses.
In China, overdue credit card debt has spiked 50% from the year prior, with delinquency rates jumping to 20%. Some banks have reported consumer defaults have quadrupled from 1% to 4% since the beginning of the crisis.
Sovereign Debt Crisis:
Almost half of the countries in the world have requested a bailout from the IMF. While at least 60 have made similar requests to the World Bank. At the start of the year, 44% of developing countries had debt considered to be high risk or distressed. Since then, three times as much money has left emerging markets than during the 2008 financial crisis.
In the developed world, sovereign debt is at record high levels. Japan, Italy, and the US all have debt levels over 100% of GDP. France, Spain, and the UK aren’t far behind.
Already this year, Argentina, Ecuador, and Lebanon have defaulted. While Zimbabwe isn’t far off. Turkey and Romania have less than 12 months of reserves to fully cover external debt. Fitch has downgraded the debt of 29 countries, with 8 being considered at high risk of default.
Countries in Eurasia, the Arabian Peninsula, Mesopotamia, Latin America, and parts of Africa are heavily dependent on oil revenues and are on the verge of default. Continued depressed oil prices will result in emergency loans, debt restructuring, and austerity measures that will further depress growth. Other countries that are heavily dependent on tourism and will face similar challenges.
Moody’s forecasts 13.7% of all speculative grade corporate bonds in emerging markets will default within a year, breaking the record reached during the 2008 crisis.
The National Governors Association said states need $500 Billion in financial support to meet their obligations. Otherwise, budget shortfalls will hit pension benefits, unemployment benefits, mass layoffs, and hospital and nursing home bankruptcies.
The Governor of New Jersey has warned of historic layoffs of public workers if states don’t receive financial aid soon. The Illinois pension fund is severely underfunded and has requested $10 Billion to meet obligations. Six states that cover one-third of the US population are set to deplete their unemployment insurance funds in less than 2 months. California went from running a $21.5 billion surplus a year ago to a $54.3 billion dollar deficit. Their new budget calls for layoffs, state workers pay cuts by 10%, cuts to education, health and human services, parks and recreation, and public safety. In April alone, a million government workers across the US were laid off.
Sales tax and income tax comprise 70% of state tax revenue, with lockdowns causing significant shortfalls in these areas. Low tax states, or states dependent on sales and tourism taxes, like Florida, Nevada, and Louisiana, could face austerity measures, tax increases or borrow heavily as they face dire budget shortfalls. Already California, Illinois, and Connecticut have received federal loans to cover unemployment obligations.
Graphing the Recovery
Double Dip: W Recession
Had the pandemic hit in 2012-2016, during the height of the recovery, we would most likely see a ‘V’ or ‘U’ shaped recovery, as the resilient economy bounced back. But, the pandemic hit in early 2020, when major portions of the economy had already had significant contractions and was well on its way to a recession. As strides are made to contain the virus and restrictions are lifted, we could see a significant jump as the economy comes back online, only to see a major deleveraging or a second spike of COVID-19 that brings it back down,ending with a long steady recovery over time.
The Big L: A Global Great Depression
The worst case scenario would be a global great depression. Countries could be caught in a debt trap of secular stagnation, disappointing growth, low interest rates and mounting debt. Fiscal and monetary policies may be focused on stopping the bleeding rather than investing in productive activities like infrastructure, education, or the medical system. While the debt levels may seem astronomical, we have been there before at the end of WW2. Failing to replace the credit that is being destroyed in the monetary system could lead to a deflationary spiral that further extends the crisis. It could take three to five years to restructure the economy before rebounding.
The National Bureau of Economic Research predicts the ‘L’ recovery is the most likely scenario. Their model anticipates 35% of people who were furloughed during the first month of the pandemic will not return to their previous employment, which is backed up by survey data. While the University of Chicago believes that number is as high as 42%.
Where Do We Go From Here?
The next step is to use your compass to determine where you’re at and how you’re going to navigate the coming storm. Are you in an industry directly impacted by COVID-19 or will you be indirectly impacted? Will you be hurt when incomes fall, the currency deflates, or when international demand dissipates for your product? Or will you be the lucky few who ride the waves of distress and come out stronger on the other side?
If you’ve been caught up in the first wave
- Waiting and seeing what will happen is a recipe for disaster. Now is the time to seek professional help. The longer you wait, the less cash you’ll have to weather the storm, the fewer options you’ll have available, the more costly those options become, and the greater likelihood of losing the business.
- If you haven’t already, create a 13-week cash flow, negotiate with landlords, be in discussions with creditors, be looking for new sources of financing, cut costs wherever possible and extend liabilities into a longer term.
- The road to ruin can be treacherous. A limited liability company doesn’t protect directors and officers from all forms of personal liability. Entering into a distressed situation changes the legal liabilities where business owners have a fiduciary duty to both one’s shareholders and one’s creditors. Working against the best interest of one’s creditors can result in personal lawsuit, not paying wages owed to employee’s can result in a personal lawsuit, not paying payroll taxes can result in a personal lawsuit. Do not put yourself in a position where you can’t walk away.
If you think you’ll be caught up in the second wave
- You have a little time to brace yourself for what’s to come, don’t waste it.
- Banks will be overwhelmed with troubled loans and have already started shifting employees internally into special assets departments. Now is the time to get ahead and start negotiating, amend and extend agreements. Build up a war chest and stress test your organization.
- Under no circumstances should you have a communication breakdown with a lender or pretend things are better than they are. This will only accelerate your decline.
- Having high revenues can both solve and hide bad business practices. Now is the time to restructure operations internally, fix all inefficiencies, and optimize the few key drivers in your business that will most improve your profitability.
If you think you’ll be affected by the third wave
- Assume worst case scenarios, 50% decrease in GDP, 30% unemployment, 1-3% currency deflation, steep declines in government, consumer, and international spending that take 3 years to return, then start planning accordingly.
- Assume suppliers and customers will go out of business and find alternatives.
- Assume tightening credit standards across the board, and find additional sources of finance, then lock in those sources now.
- Evaluate mergers with competitors or a sale to strategic or opportunistic acquirer.
If you think you’ll be spared until the fourth wave
- Do not assume life will return to normal or that things will go back to the way they were before. Constantly question how things will be different. According to Gallup 60% of employees want to remain working from home, while only 40% want to return to office life. If companies shift to a plurality working from home, then those employees can work from anywhere. This could lead to mass migration as employees would seek higher quality of life by moving out of mega cities into mid size cities or out into the countryside. New industries could form to cater to the work from the home sector. Restaurants would be replaced with ghost kitchens, houses would be renovated to have offices, cities could sprawl further as people no longer have to commute. This is one scenario, brainstorm as many as possible to understand just how transformative COVID-19 might be.
- Be vigilant on new trends on how your customers’ tastes are changing and ensure you’re changing with them. Don’t find yourself becoming the next Sears.