Over the past several weeks, as the severity of the economic impact of the COVID-19 pandemic has become more apparent, economists and research analysts at major financial firms have revised down their GDP estimates for the first half of 2020. On March 31, Goldman Sachs changed its estimates for a 6 percent contraction in the first quarter and 24 percent in the second quarter to down 9 percent and 34 percent, respectively. They also bumped up their peak unemployment rate estimate to 15 percent, from 9 percent. Other market participants have made comparable revisions to their economic outlooks for the first half of 2020, alongside corollary predictions that economic activity will rebound ferociously in the second half (Goldman is estimating a 19 percent third-quarter bounce in GDP growth).
Global capital markets have responded as expected to this radically changed economic environment, with prices of risk assets among the hardest hit. While U.S. equity markets have experienced significant volatility and equity indices are close to 30 percent off their recent record highs, leveraged corporate credit — high yield bonds and leveraged loans — arguably have taken a more significant hit. On April2, Fitch Ratings revised its baseline and downside scenarios for corporate defaults in the U.S. and Europe in 2021-2022 to a range of 12-15 percent and 17-25 percent, respectively. By comparison, 2019 ended with a 3.1 percent default rate.
These estimates notwithstanding, a “short and (very) sharp” recession may lead market participants and observers to assume that corporate credit markets — in their own right, but also as indicia for the prospect of a material wave of corporate financial restructurings — will snap back in a manner similar to that believed for projected economic activity. Yet, there are many reasons the COVID-19 recession of 2020 may become a catalyst for a U.S. restructuring and bankruptcy cycle of materially longer duration.
A long, slow boom. With apologies to public health professionals, the U.S. economy’s recovery from the 2008-2009 financial crisis was a prime example of a “flattened curve.” The fiscal and regulatory drag associated with late Bush and Obama administration policies, combined with significant Federal Reserve activity in the form of quantitative easing, resulted in a long but shallow economic recovery. Extended periods of economic growth, however weak, allow for structural excesses — a decline in lending standards, excessive leverage, financial engineering without underlying economic purpose — to accrete and build to dangerous levels. Moreover, human nature endows all of us, including financial professionals, with short memories.
A Federal Reserve low on ammunition. In response to the 2008 financial crisis, the Federal Reserve increased the size of its balance sheet from $870 billion in August 2007 to $4.5 trillion at its pre-COVID peak in early 2015 to provide the capital markets with liquidity and inspire confidence among market participants. After declining modestly to under $3.8 trillion in September 2019, the Fed’s balance sheet grew by over $1 trillion in March 2020 alone to over $5.2 trillion, leaving it in uncharted territory. Having fired more than a few bullets to shore up investor sentiment during the early moments of the COVID-19 outbreak, the Fed’s future financial wherewithal is uncertain. A Fed with less fuel in the tank — along with uncertainty about the duration and defensibility of its emergency lending authority — arguably leaves the Fed’s cupboard worryingly bare.
Changes in the post-crisis financial architecture. As I wrote in late 2018, the intermediation of corporate credit has changed meaningfully since the 2008 financial crisis; unregulated entities (collateralized loan obligations, business development companies and private debt funds) largely have displaced regulated commercial lenders among significant segments of the corporate lending market. The durability of this new financial architecture has yet to be tested widely. There are objective reasons to believe the lack of regulatory oversight, underinvestment in credit infrastructure, structural and documentary limitations, and carried interest financial incentives associated with these lending formats may not prove up to the task of navigating a leverage markets tsunami.
Multi-constituent pain. Past credit downturns and recent significant financial restructuring cycles were marked by disproportionate distress concentrated in certain sectors, such as energy, or segments of industrial value chains, while other parts of the economy remained relatively healthy. Even broader economic downturns have experienced pockets of relative industrial strength within an otherwise ugly macro-environment. None of these recessions, however, evidenced an effective shutdown of considerable swaths of the economy as is the case with COVID-19. Consider the example of a toy store: Demand vanishes because children aren’t having birthday parties and people can’t shop, resulting in canceled orders and an inability to pay vendors. Employees are laid off because of shelter-in-place mandates, landlords cannot find a replacement tenant, and lenders dare not push for a liquidation of collateral through going-out-of-business sales no one can attend. Who blinks when all is frozen and parties are unable to run their customary workout playbooks?
Fundamental changes in behavior and socioeconomic arrangements. A standard premise underpinning financial restructurings and reorganizations is that an operational or financial fix — whether it be shedding obligations, shuttering money-losing divisions, raising fresh capital, or converting debt-to-equity — will address a company’s problems and return it to terra firma. But what if the ground isn’t so stable? We may be in the earliest stages of acknowledging potentially permanent changes in consumer behavior and economic organization. How does one assess the prospects of a restaurant chain when one is unsure whether people will still want to eat out, or at least to the degree and manner that they did previously? Will people still want to take cruises? What does the ready acceptance of Zoom video conferencing suggest for business travel? Will corporate America “onshore” strategic sectors and industrial supply chains, and if so, what are the economic implications? Lightning-speed, “in and out in a day” pre-packaged Chapter 11 bankruptcy filings — which were all the rage for restructuring companies near the end of the long boom — likely will be less common as these tectonic shifts reveal themselves over time.
Nobody has a crystal ball, and few would have guessed a global pandemic would be the catalyst for the next recession. Similarly, in these still early days of a public health crisis, it is impossible to know exactly what the future might hold — economically or otherwise. But the factors above certainly suggest a much longer and deeper process of decomposing and reconstituting traditional economic arrangements and the companies operating within them. Moreover, given the severity of the economic impact of the downturn on individuals and businesses, the risk of unpredictable government action — for good or ill — is correspondingly heightened.
Fasten your seatbelts. It’s going to be a bumpy ride.
Richard J. Shinder is a financial services executive in New York and founder of Theatine Partners, a financial consultancy. In a 25-year Wall Street career, he has worked in various advisory, principal and managerial roles for firms including The Blackstone Group, Goldman Sachs and Perella Weinberg Partners, among others. Follow him on Twitter @RichardJShinder.