Nine Months Later . . . And Still Ticking

In late September of last year, I wrote a Briggs Blog entry titled “The Ticking Time Bomb Of Corporate Debt” where I expounded on my thesis that the corporate debt market being forced to come to terms with a higher interest rate environment could result in an economic crash rivalling, perhaps even exceeding what happened during the 2008-2009 financial crisis. In this blog entry, I intend to speak on the points I made in the previous article with updated data, as well as new information and perspectives on this topic. It is my belief that not only has the data not improved in these last nine months, but that the fallout could be even worse than I previously estimated.

A Reminder of the Reaction Function: What Do When Debt Due?

Companies will have to respond in one of a few ways as the debt they have previously issued under much more accommodative conditions matures. I outlined three options for how they can navigate debt maturities as they come due.

1. They can pay back the loan in full. Several companies have already engaged in significant cost cutting, which has resulted in a stem of white-collar job layoffs. Unemployment has ticked up from 3.8% to 4% in the last nine months (U.S. Bureau of Labor Statistics, 2024), and the average weekly hours of all employees has also fallen from 35.0 hours per week in April of 2021, to 34.3 hours per week in May of 2024, suggesting there may be more room for additional layoffs later in the year (St. Louis Fed., 2024). I expect this trend of waves of layoffs to continue in the second half of this year as companies react and prepare for 2025. I estimate the unemployment rate will be 4.5-5.0% by the end of 2024.

One key challenge with this approach is that for it to be successful, the company is essentially forfeiting the resources required to foster medium and long-term growth. This raises concerns that even if they service the debt and either reduce it or eliminate it entirely, the company is not out of the woods. It has given up a considerable competitive advantage, which introduces a new form of risk where an outside competitor that is better positioned can either outcompete or simply buy the business, which likely also results in layoffs.

2. They can attempt to survive and refinance the debt. A number of companies are in fact either refinancing or negotiating with creditors to kick the proverbial can down the road. Yields have not meaningfully increased since I last wrote – quite the opposite – although I would offer these two charts for comparison, showing that in 2005-2007 the bond market was all but entirely unaware of the risks on the horizon in 2008 and beyond. During that time, the Fed funds rate was held at 5.25% from June 2006 through August 2007 – the same rate it is currently at and has been since July 2023. The yield spreads, save for the CCC tranche, are very narrow, and the chart contours and level/velocity of movement downward is virtually identical. There was a large amount of demand for credit in 2007 as bond investors were afraid of “missing out,” and I would argue the same sort of mania for “high-yield exposure” is biting us once again today, driving yields down even as risk factors mount.

While the Fed did move later in 2007 to lower rates, it should be noted that when Bear Stearns failed as an institution, the Fed funds rate was 3%, and when both AIG and Lehman Brothers failed later in September 2008 the Fed funds rate was under 2% (St. Louis Fed., 2024). What this demonstrates is that even if the Fed lowers interest rates later this year, the structural damage – the erosion of value – has likely already taken place and is only a matter of time for the proverbial dominoes to come crashing down on one another.

3. They can figure out that they are a pretender and try to find a suitor to buy them. With respect to companies kicking the can down the road, some creditors have chosen to accommodate that, taking less yield or none at all in the short term in the hopes of preserving the value of the bond in the long-term; the colloquial phrase being used by creditors for this is “extend and pretend.” During the rest of 2024, $160.4 billion of speculative grade debt comes due (markedly lower than the $591 billion for all of 2024 I cited previously). However, this number balloons to over $1.15 trillion due in 2028 (Gunter et. al., 2024). That said, companies likely have had to pay considerably for said consideration, and creditors at any point could come to collect should an economic collapse appear imminent. This may buy a little more time for a company that makes no money – a “zombie company” – to find a suitor, but it does not ultimately impact the dynamic that the company is unprofitable and cannot stand on its own two feet in any economic environment, favorable or otherwise. We have already seen a number of deals and potential deals along these lines announced in the energy, entertainment, health care, and technology spaces, and I expect this behavior to accelerate in the back half of 2024 and into 2025 as companies with value scramble to get as good of a deal as possible ahead of their financing events.

The Default Wave Has Continued To Increase, Yet The Hopium Floweth

According to S&P Global, speculative-grade corporate debt had a default rate of 3.24% through June 2023, with a baseline default scenario of 4.5% by June 2024 (S&P Global Ratings Research, August 2023). Well, in May 2024 that number was already at 4.8%, with the low-end number of defaults from S&P Global’s projection increasing from 33 defaults just nine months prior to 50 defaults, yet maintaining essentially the same midpoint and upper-bound estimates stating that “economic growth and corporate profits remain broadly healthy” (S&P Global Ratings Research, May 2024). Yet according to Groundwork Collaborative, an economic think-tank, “From April to September 2023, corporate profits drove 53% of inflation” (Groundwork Collaborative, January 2024).

This raises a big question: What happens if consumer demand markedly slows, and thus economic growth and corporate profits can no longer be sustained as “broadly healthy?”

The Consumer Is Already In The Bad Place . . . And It Is Just Beginning

According to the Federal Reserve Bank of New York, 10-15% of the generations most completely engaged in working (Gen X through Gen Z) are maxed out on their credit cards (Haughwout et. al., 2024). The percentage of maxed out borrowers (90-100% credit usage) transitioning into delinquency is well above 30%, the worst rate that has been seen in over a decade (Haughwout et. al., 2024).

Moreover, 10.7% of credit card debt balances are 90+ days past due (Center for Microeconomic Data, 2024). This 10.7% delinquency number is a massive spike upward from the 8% level measured in Q2 2023, reported around the time I wrote the previous article. The last time we saw 10.7% of credit card debt balances 90+ days past due is in 2012, which came off a high of 13.73% in Q1 2010 because of the Great Recession (Center for Microeconomic Data, 2024).

Additionally, despite the Federal Reserve increasing and then holding interest rates at 5.25% for nearly a year, inflation has seemingly been stuck at a median growth rate of 3.34%, with a range of 3.18% to 3.7% during the past year (U.S. Bureau of Labor Statistics, 2024). This creates a dynamic where the cost of borrowing is more expensive – in fact, the current credit card bank interest rate of 21.59% is the highest borrowing cost rate on record for consumer credit going all the way back to Q4 of 1994 when they first started tracking and reporting this data; borrowers that are being assessed interest currently have an average interest rate 22.63% (Center for Microeconomic Data, 2024).

None of this accounts for the $1.6 trillion in student loan debt that exists, which by statute will not have any defaults reported until Q4 2024, notably after the Presidential election (Center for Microeconomic Data, 2024).

Nor are any of the defaults that stem from Afterpay, Affirm, Klarna, PayPal, and others with their “buy now, pay later” schemes reported here either.

And the personal savings rate is a paltry 3.8%, hearkening back to 2006-2007 before the financial crisis took place.

What could possibly go wrong?

Commercial Mortgage-Backed Securities: The “Default” Setting

Thanks in part to a variety of forces, including increased remote work opportunities and zombie corporations going under, commercial real estate demand has plummeted with the office vacancy rate increasing by 50% in the past year (Kupiec, 2024). Kupiec (2024) further asserts that “there is the potential for significant bank losses if it proves to be uneconomic to refinance many commercial properties when their current financing comes due” (p.2). Reidy et. al. (2024) from Moody’s, an analytics and ratings agency, found that not only have CMBS defaults grown from 34.5% in 2023 to 43.5% in the first quarter of 2024, they found that if you excluded the payoffs by Google and Amazon of their office portfolios, the YTD payoff rate would be just 21% – down 45% from the prior year. Remember the phrase I used earlier of “extend and pretend” regarding corporate debt? That is what is happening here too – when payoffs aren’t happening, creditors are offering additional loan terms to attempt to accommodate the current rates as a temporary phenomenon. The concern with this behavior, going to Kupiec’s point, is this question – with the withdrawal of companies wanting to lease space, rents coming down and vacancies catapulting, at what point does the borrower decide to walk away from it and default?

These data points seem to support Kupiec’s concern that there are hundreds of small and mid-sized banks that may have unrecognized interest rate losses stemming from this behavior, meaning that there could be hundreds if not thousands of small banking institutions (less than $1 billion in assets) that may have outsized exposure to commercial real estate risk. Kupiec (2024) estimates that if a 10% loss (which is considered a “mild” stress event) were experienced in non-owner occupied, nonfarm nonresidential commercial real estate loans, “71 banks with assets under $1 billion and 79 banks with assets between $1 billion and $50 billion would be rendered market value insolvent” (p. 29) implying a loss in market value of approximately $570 billion. If an across-the-board 10% loss in commercial real estate were to occur, 628 banks holding $1.4 trillion in assets would be insolvent. A loss of that magnitude could wipe out FDIC entirely unless additional assistance from other member banks or the government were provided.

Misrated Debt is Still a Major Threat

The meaningful rating of debt, particularly debt close to the investment grade/speculative grade line, has not improved, and the poster child for said immutability is Boeing. Boeing is still BBB- rated, investment grade, in spite of the company not being able to consistently build a commercial plane in half a decade (coincidentally its last profitable year was 2018). Its liabilities are up 32% over the past five years, it has no ability to pay off its debt that is maturing so it’ll need to be refinanced – and yet that is somehow “investible.” Well, I am here to say as clearly as I possibly can that not only is Boeing in my opinion not investible, but there is likely a wide swath of companies not identified yet that are considerably riskier than these ratings agencies might lead one to believe.

Small Businesses May Suddenly Suffer

61.6 million Americans, appoximately 46% of the total employed workforce, are employed by small businesses (Ferguson, Hoover, and Lucy, 2024). From mining, manufacturing, and transportation, to retail, professional services, and leisure, the risks previously described affect these companies and their employees as well. Financing availability and rates are typically worse for small businesses, so credit will become increasingly untenable should small businesses need these resources. Many small businesses exist in large part to the larger businesses that are nearby – the local restaurant that is a quick walk from the factory or the large office building. Defaults that shutter larger businesses, or cause buildings to be foreclosed upon and potentially be torn down, will likely cascade into making it difficult for small businesses who rely on those centers of activity to survive. This is confirmed by the U.S. Chamber of Commerce’s data, showing that “42% of small businesses fail due to lack of market demand, [and] 38% of small businesses fail due to lack of capital” (Ferguson, Hoover, and Lucy, 2024). In my previous article I focused on the unemployment numbers for publicly traded corporations; we could easily see similar or potentially larger unemployment numbers come from the small business space.

This also affects building equality in diversity and business leadership. According to Huerta (March 2024), just 8% of the S&P 500 CEO positions are held by women. In sharp contract, 40% of small business owners are women (Ferguson, Hoover, and Lucy, 2024). Many great companies and new ideas stem from the development and growth of small business. However, when the governing dynamics of building a business from the ground up are already at a disadvantage, and then that disadvantage is compounded further by those governing dynamics having an outsized impact on the small business relative to its larger peers, economic growth is stunted, innovation are stunted, and equality in leadership is stunted.

Many Threats, Few Answers, Be Prepared

As I stare down this list of various threats and challenges the U.S. economy faces, a reasonable question is simply “What do I do about it?” Broadly, there is very little to be done about what is happening in these spaces – the market has created these scenarios and situations, which may play out in part or in whole, potentially all at once in concert. What I see here is an interconnected web of various risk factors that could all potentially act as a catalyst for other risks to be realized. I was recently asked in an interview in Business Insider what I thought the worst-case scenario could look like for unemployment, which I replied that by the end of 2025, we could be staring down a 10-15% unemployment rate if most or all of this comes to pass (Sor, March 2024). I am unchanged in that viewpoint.

So then if you cannot escape the storm that is coming, then you need to prepare to weather it. Building a higher-than-normal amount of emergency savings, paying off any high-interest rate debt, and avoiding taking on new debt, if possible, should be prioritized. This does not mean to avoid investing, because I will be quick to point out that this thesis, grim as it may be, is a possibility, not an eventuality. There are several potential events I cannot account for that could change, perhaps significantly, this narrative.

My concern rests in helping you both understand where these threats may emerge from and help you be as well prepared as possible such that if this economic hurricane slams right into us, that you are as prepared as possible to come out the other side relatively unscathed, even if you faced prolonged unemployment and/or other life risk events. While I believe that history does not repeat, I do believe it rhymes, and much of what is going on – the data, the attitudes – sound an awful lot like 2007. Many people would have been extraordinarily thankful for a clear warning back then. If I am wrong, I imagine you will forgive me for asking you to prepare yourself well. But if I am right, and I really hope I am not, but if I am right, I hope all of this work will help you avoid the pain and the major setbacks many faced in the Great Recession and its aftermath.

References

Center for Microeconomic Data. (2024, May 14). Household debt and credit report. Federal Reserve Bank of New York. Retrieved June 11, 2024, from https://www.newyorkfed.org/microeconomics/hhdc

Default, transition, and recovery: The U.S. Speculative-Grade corporate default rate could rise to 4.5% by June 2024. (2023, August 7). S&P Global Ratings. Retrieved September 22, 2023, from https://www.spglobal.com/ratings/en/research/articles/230817-default-transition-and-recovery-the-u-s-speculative-grade-corporate-default-rate-could-rise-to-4-5-by-jun-12825499

Default, Transition, and Recovery: Resilient growth, resilient yields, and resilient defaults to bring the U.S. Speculative-Grade Corporate Default Rate to 4.5% by March 2025. (2024, May 16). S&P GLobal Ratings. Retrieved June 11, 2024, from https://www.spglobal.com/ratings/en/research/articles/240515-default-transition-and-recovery-resilient-growth-resilient-yields-and-resilient-defaults-to-bring-the-u-13106413  

Federal Reserve Board – Consumer Credit – G.19. (2024, June 7). Retrieved June 11, 2024, from https://www.federalreserve.gov/releases/g19/current/

Ferguson, S., Hoover, M., & Lucy, I. (2024, June 5). Small business data center. Retrieved June 14, 2024, from https://www.uschamber.com/small-business/small-business-data-center

Gunter, E., Drury Byrne, P., Limbach, Richhariya, N., & Balasubramanian, Y. (2024, February 5). Credit Trends: Global refinancing: Maturity wall looms higher for Speculative-Grade debt. S&P Global. Retrieved June 11, 2024, from https://www.spglobal.com/ratings/en/research/articles/240205-credit-trends-global-refinancing-maturity-wall-looms-higher-for-speculative-grade-debt-12991317

Haughwout, A., Lee, D., Mangrum, D., Scally, J., Van Der Klaauw, W., & Wang, C. (2024, May 14). Delinquency is increasingly in the cards for Maxed-Out borrowers – Liberty Street Economics. Liberty Street Economics. Retrieved June 11, 2024, from https://libertystreeteconomics.newyorkfed.org/2024/05/delinquency-is-increasingly-in-the-cards-for-maxed-out-borrowers/

Kupiec, P. (2024). Commercial real estate and bank systemic risk. In American Enterprise Institute. Retrieved June 11, 2024, from https://www.aei.org/wp-content/uploads/2024/05/Banking-system-exposure-to-commercial-real-estate-may16-final.pdf

New Groundwork report finds corporate profits driving more than half of inflation – Groundwork collaborative. (2024, January 18). Groundwork Collaborative. https://groundworkcollaborative.org/news/new-groundwork-report-finds-corporate-profits-driving-more-than-half-of-inflation/

Reidy, M., Rosin, C., Fagan, K., & Roy, T. (2024, May 20). Office Loan maturity monitor: Has the dust settled, or is there hope for further workouts in the future? Moody’s Analytics CRE. https://cre.moodysanalytics.com/insights/cre-news/office-loan-maturity-monitor-has-the-dust-settled-or-is-there-hope-for-further-workouts-in-the-future/

Sor, J. (2024, March 12). Layoffs could be coming as debt-laden firms navigate the pain of higher rates, economists say. Business Insider. https://www.businessinsider.com/layoffs-recession-economy-job-market-outlook-fed-interest-rates-debt-2024-3

St. Louis Fed. (2024, June 7). Average weekly hours of all employees, total private. Federal Reserve Bank of St. Louis. Retrieved June 11, 2024, from https://fred.stlouisfed.org/series/AWHAETP

St. Louis Fed. (2024, June 3). Federal funds effective rate. Federal Reserve Bank of St. Louis. Retrieved June 11, 2024, from https://fred.stlouisfed.org/series/FEDFUNDS

U.S. Bureau of Labor Statistics. (2024, May 15). 12-month Percentage Change, Consumer Price Index, Selected Categories. Retrieved June 11, 2024, from https://www.bls.gov/charts/consumer-price-index/consumer-price-index-by-category.htm U.S. Bureau of Labor Statistics. (2024, June 7). Civilian unemployment rate. U.S. Department of Labor. Retrieved June 11, 2024, from https://www.bls.gov/charts/employment-situation/civilian-unemployment-rate.htm