The Bankruptcy Breakdown Transcript

Abstract: Aug. 1 -- In 2020, bankruptcy has gone from the last resort for struggling companies to "the new normal." Blaming it on the coronavirus alone is too simple. Lisa Abramowicz hosts an in-depth look at the sudden surge in corporate defaults, how it's affecting investors, and why policymakers are finding it challenging to contain the damage.

Editor Note: The following is a transcript of Bloomberg's Special Report on the pending post-pandemic bankruptcy environment in the United States. This report is a cautionary tale for all Western developed nations. We've taken editorial license and inserted commentary based on our executive search experience.

Transcript:

Time Stamp 0:01

The COVID-19 pandemic has throttled economic activity and dragged down corporate profits and as the disease has spread a cascade of bankruptcies is following with no end in sight.

James Gorman, Chairman & CEO, MorganStanley - It's a natural consequence small and big businesses are struggling when you know they haven't got clients coming in. 

Bloomberg: The prognosis is grim for many companies and entire industries, not to mention for investors caught in an outbreak of distress.

Lisa Donahue, Co-Leader of Turnaround & Restructuring, AlixPartners Global - I do think people are going to have to be patient, and people are going to have to be creative.

Bloomberg: Meanwhile, governments and central banks are pulling out all the stops to slow the torrent of bleeding red ink.

Matt King, Global Markets Strategist, Citigroup - "... that has distorted normal recessionary dynamics, and we didn't respond to many of the critical differences which we're likely to see over the longer term.

Abramowitz - 0:52

What is driving all these defaults, and how deep will the damage go? Welcome to a Bloomberg special report, the bankruptcy breakdown. I'm Lisa Abramowitz; the size of the current bankruptcy crisis is painfully evident. Each week we get more firms joining a parade of businesses filing for protection. In this report, we'll examine the shape of the problem. How it's spreading through the larger economy, and why policymakers are finding it so challenging to contain. Let's begin with a look at how quickly bankruptcy has gone from last resort to the new normal.

Bloomberg - 1:43

Thus far, the year 2020 has been an unprecedented year for corporate unravelling, never before have so many retailers and healthcare companies gone bankrupt in such a short time. Every sector has gotten hit, from the beaten-down shale patch to airlines to sports leagues. Companies have all placed the blame for bankruptcy on the pandemic, which is partly true, but many were already fragile after taking on record amounts of debt during a decade of low-interest rates.

Hertz is a perfect example. The iconic rental car company filed for bankruptcy in May with revenues all but drying up as travel ground to a halt. But it had also failed to build a big enough cash cushion relative to its $24 billion of debt. Hertz's story is not unique. This year may end up being the worst period for corporate defaults in history.

The six biggest USA banks set aside $35 billion in the second quarter alone to cover potential loan losses. The numbers would be far worse if policymakers didn't fire a bazooka injecting trillions of dollars of fiscal and monetary support into the global economy. These measures have propped up markets and encouraged investors to plough into riskier securities. But all that hasn't been enough to offset the consequences of a recession. Companies are still struggling to survive with little income and ballooning debt after borrowing record amounts of cash to stay alive during the pandemic. Investment-grade companies in the USA sold a staggering $1.3 trillion of bonds in just the first half of the year exceeding all of last year's issuance by more than $65 billion.

Defaults, downgrades and distress. By one model, this year's spate of mega bankruptcies is just getting started. Take a listen to recent comments from Ed Altman, NYU professor and creator of the Z Score, which determines corporate distress.

Altman - 3:30

"There are now, probably about $33B in bankruptcies so far this year and if that continues at a similar rate for the remainder of the year, you're talking around $65B. The previous high for mega bankruptcies was 2009, measuring at $49B. So, we will easily surpass that record. And that's partially due to this huge increase in high yield bonds and leveraged loans of companies that are very large. We've seen some very, you know, clear numbers about this with a very well known company."

Bloomberg

Credit analysts are trying to game out just how bad things could get. In its best-case scenario, S&P Global expects the US default rate among high yield companies to hit 12.5 per cent by March, which would rival peaks last seen in 2009 and 1991. In the worst-case scenario, the credit rating company sees the rate spiking above 15%, which would by far be the highest in modern history. Still, despite the precarious debt burdens, many companies are borrowing even more to survive. Ralph Schlosstein, Co-CEO of Evercore and former president of BlackRock laid it out on Bloomberg Surveillance.

Schlosstein - 4:57

In 2008 and 2009, we learned that financial institutions failed not because of capital, but because of liquidity. And in this recession, deep recession, we have also learned that that phenomenon is more widespread. So we've spent a lot of time in the last four months, encouraging companies to put more cash on their balance sheets.

Abramowicz - 5:23

But here's the conundrum Ralph, because we're heading into a period of slowing growth, we have a more fragile economy. We have more indebted companies, why not just file for bankruptcy, why not renegotiate the debt loads now with creditors to reduce the obligations rather than putting their entire capital models in a more precarious situation.

Schlosstein - 5:43

Well, there's some of that going on as well. I think there's the real issue in terms of how to solve one's balance sheet issues depends upon the outlook for the business. If we are truly in a V-type recovery, then it's just a matter of having the cash to survive to the other side of the chasm. Other businesses, obviously are going to be more seriously and permanently impaired and for them you know bankruptcy and recapitalization is the right model.

Bloomberg - 6:26

Banks are girding for things to get worse setting aside and billions of dollars to absorb losses tied to future insolvencies Morgan Stanley's James Gorman told Bloomberg he sees a little chance that banks can get ahead of the reckoning that's coming.

Gorman - 6:41

Well, I don't know that you can get ahead of it! I mean, it's a natural consequence, small and big businesses struggling when you know they haven't got clients coming in. I mean, look at the restaurants look at all the small businesses - the hairdressers, the doctors and the dentists - before you even get too big companies. So you know, that's part of why we saw such a massive wave of financing in the last quarter, as a lot of companies got ahead of that and built up stronger balance sheets in anticipation these tougher times.

Bloomberg - 7:11

The cost of this crisis will be massive, both socially and economically. Many investors are already cutting their losses and selling holdings and distressed companies at steep discounts. But others are eyeing opportunity. NYU's Ed Altman weighs in.

Altman - 7:27

"With these vast amounts of new bankruptcies, and defaults, the supply and demand for these securities have tipped much more toward a buyers market. Investors in distressed assets are somewhat pleased about what's going on. They've been waiting for this deluge of new bankruptcies and defaults - and what it means in terms of recovery rates to the existing investors and creditors but also what they have to pay to purchase these companies. Many of which will be restructured in Chapter 11. And that's now signalling a booming market for the distressed debt market with money flowing into these funds at a fairly high rate at this point."

Bloomberg - 8:26

Investors watched with alarm as default surged in the first half of 2020. In June, Marathon Asset Management CEO Bruce Richards told Bloomberg, he sees even more trouble ahead.

Richards - 9:08

There's a lot of problems brewing. And so, what to expect with default rates? Since the beginning of COVID, since mid-March, we've recorded at Marathon, 60 bankruptcies here in the United States, totalling about $100 billion. And we think this $100B number will grow to $400 billion. That is the 4.5 per cent default rate and will rise to 18% cumulative, which takes you to an annual default rate of about 10 per cent. The default rate, as you know, is measured in trailing 12 months.

Bloomberg - 9:51

Welcome back to Bloomberg special report the bankruptcy breakdown. I'm Lisa Abramowitz, Richards like many others, expects to see a surge in defaults as the year progresses but bankruptcy is not a one size fits all solution. Some companies will cease to exist. Others will restructure and emerge whole. Still, with no prospect of a quick economic recovery, it's challenging to devise a plan to stay afloat. I asked, Lisa Donohue, Co-leader leader of turnaround and restructuring at AlixPartners Global, how she thinks companies will be approaching these challenges as the pressure of debt intensifies.

Donahue - 10:23

It's going to be an individual type situation; the USA's Chapter 11 can be an effective tool. And remember the USA Chapter 11 is more about actual rehabilitation, the fixing of a company and having it come out on the other side. Whereas, sometimes in other countries, it's more about a managed wind down. So what bankruptcy can do for some of these companies, if they find that they're mostly running out of cash which is one of your inflexion points for figuring out what's the right thing to do. You can de-lever, you can more effectively shed non-core businesses, you can effectively look toward closing unprofitable operations, things like that. So, it's a tool to help some of these companies deal with perhaps lingering problems that they've had. So it's not necessarily an end of the road, but Chapter 11 can be a tool to help some of these companies out.

Abramowitz - 11:24

Given the scope of bankruptcies and the scope of the pain. Given how much debt was built up over the decade, ahead of this. How low do you expect some of the recoveries to be for debt investors,

Donahue - 11:39

You know, predicting debt recoveries is something that I don't think anybody wants to do. But I will say this; I was reading analysis about the typical recovery time post a recession is averaging somewhere around three to three and a half years to get back to equilibrium. When I say equilibrium, I mean back to pre-pandemic, pre-recession normal operating levels from a manufacturing operational perspective. I don't necessarily think that the recoveries are going to be less than prior recessions. Still, I do think people are going to have to be patient, creative and recognize that this is something that we've never seen before. The strong companies will come out on the other side, and smart management teams will proactively look for ways to extend their runway and to manage through a lower productive environment to get to profitability on the other side.

Abramowitz

How concerned are you that corporations are borrowing more and more money, billions of dollars to get to the other side. When they don't know what the other side will look like or when getting there will be?

Donahue

You know, I'm less concerned with companies that are doing that, because to preserve their value and to get to the other side, they need liquidity. The capital markets are very frothy right now with a lot of liquidity out there. So I would say it's not just the amount of debt to look at, but how their debt behaves. What kind of debt they have, how long term it is, how prompt it is, when their maturities are, what sort of flexibility they have to build into their debt.

Now, obviously, too much debt is never a good thing. I've talked with a good deal of CFOs and CEOs of healthy companies that did proactively go out and raise capital, with the intent of managing their cash so that when they do get to the other side, and it is clear on what's going to happen, they can quickly pay it back down and de-lever. So it's not a question of issuing debt for debt sake, it's a question of getting the flexibility that you need from a liquidity perspective to weather through whatever period, we're looking at with this pandemic.

Abramowitz - 14:14

What's the next industry that you think is likely to get hit.

Donahue - 14:26

Wow! I don't think we're done with energy. I think oil and gas will continue to struggle for a whole host of macro factors that are not necessarily pandemic related.

I think we should be looking to see what's happening with real estate.

The longer this pandemic goes on, we may see larger enterprises that might typically not have any distress, end up going into distress. 

Automotive is ripe for disruption. Given everything that's happening in their supply chain and with it moving toward electric vehicles, that's something that could accelerate changes.

I think aerospace and defence is an area of concern. We are continuing to be vigilant, particularly with what's happening from a perspective of distress within the supply chain to these big majors.

And hospitality, I think that the whole hospitality segment is geared on people moving, vacationing and having the ability to rent cars, stay in hotels, take cruises, fly on planes and as long as people aren't moving, the trickle effect will place the hospitality industry in a lot of trouble.

Bloomberg - 15:55

Coming up next is policy, policymakers have acted swiftly and aggressively to throw lending lifelines to struggling companies and city groups. Matt King thinks they may just be postponing a crisis and not preventing one. In many respects, King believes what is happening is effectively zombification, where businesses remain alive, which normally would have unfolded.

Bloomberg - 16:22

Welcome back to a Bloomberg special report, the bankruptcy breakdown. I'm Lisa Abramowitz. While the economic impact of the COVID-19 pandemic has been devastating, the response from policymakers has been extraordinary. How effective their response remains to be seen. I asked Citigroup's Matt King if he thinks this unprecedented stimulus will head off a bankruptcy crisis, or just postpone a destructive second wave.

King - 16:44

The standard joke is you don't become solvent by borrowing more money. And what is it that we've done? We've massively facilitated borrowing of more money by corporates across the board, including SMEs. Even consumer incomes have increased, once you include all the government benefits - which is really weird during a recession. Normal recessionary dynamics have been distorted, resulting in a postponement of many of the credit consequences which we'll likely see over the longer term.

At the same time, as businesses reopen but need to spend money engaging in distancing whereas they find that they've tapped the extra liquidity but still haven't got the revenues. We do actually expect to see a steady stream of further problems, and some of those have been showing up already in downgrades from the rating agency and defaults. The weird thing, therefore, is not so much the way that the problems haven't occurred, it's how the problems have occurred, haven't created the contagion or haven't had the broader market effect on the repricing that we would typically have expected.

Abramowitz - 17:51

Do you think that there will be some sort of contagion or effect later on as the pandemic continues?

King - 17:58

That is feeling less and less likely. So, I think an awful lot depends on how the central banks respond and whether they act as a backstop in the way in which they sort of claim to be doing, or whether they do what I fear they're actually doing, which is inflating larger and larger bubbles.

So, in many respects, what we think is happening is effectively zombification. Businesses are remaining alive that would normally have folded by now and then we can debate whether or not that's good. But at a minimum, it makes everything less abrupt than it might normally have been. At the same time and if the central banks are prepared to give this backstop liquidity to prevent markets from overreacting, including the prevention of fire sales and outflows as they were doing in March, then I think everyone would agree that that is a good thing.

There was this concept in the 1930s that bankruptcies should be allowed to burn themselves out, and if they didn't burn themselves out, they actually built on one another. The whole thing turned into a disaster, and so in that respect, it's very very good what's happening.

At the same time, there is this more inflated "other look" at market valuations. There is this weirdness, where we're getting the worst economic data that we've had since the 1930s and even if we've probably seen the bottom, there is now this massive gap between that and market valuations. Equity markets, in some cases, recently having made new highs almost as though nothing happened. And the more inflated to those valuations I think the greater is the risk we will recognize the lack the fundamentals. 

Abramowitz - 19:28

When you talk about pushing out the pain, the idea that a lot of these companies that have been in dire straits have borrowed more money to stay alive, will that have possibly worse consequences down the road? The idea that debt loads have gotten bigger at a time of slowing growth and increasing potential of risk aversion down the line if central banks pull back.

King - 19:59

It depends a little on what you mean by worse. So, can it be worse than what we have seen to date, even if it's not the nice bounce back and fully V-shaped recovery and return to the way things used to be? Yes, absolutely. You can't carry on leveraging up indefinitely. And in principle, Yes, could you imagine something even still, whereby the central banks lose control of the markets requiring a nasty sell-off. Yes, I could imagine the more elevated the valuations and the more debt there is in the system, the greater is this vulnerability.

However, most of what I would expect though is a bit more benign, and it's this sort of zombification or Japanification. It's a bit of a continuation of what we've seen in the last few decades, which is there's more and more debt in the system. Whenever real interest rates edge upwards, the market suddenly sells-off as people take money out and go back into risk-free assets, precisely because they were sort of forcibly being crowded into buying riskier assets. And so you've become kind of more and more trapped in this environment with a large debt overhang, but where equally it doesn't quite erupt into uncontrolled bankruptcies, and they perform in the way you would have imagined.

Abramowitz 

Given where policies are right now, which regions, do you expect to actually see insolvency, where policymakers might allow companies to go bankrupt at a faster pace? 

King

It's been a bit less about one region being more effected, and a bit more about how the effects moved away from the large corporates which could be more systemic for example with the Fed buying fallen angels. And the effects of being a bit more concentrated on the small and medium-sized companies, maybe hitting bank loan portfolios, rather than the names which are big in the bond market and by and large, I expect that to be the case centrally.

There are also interesting differences that we haven't fully seen play out. I think there's a big difference between us in the UK and somewhere like the US, where up until now you've been incentivized to pay your rent, pay your utilities, pay your employees, and then the loans can become grants. And then, say somewhere like the UK, where instead it's almost been the opposite. Here, we've not been able to evict a tenant that wasn't paying their rent as always, so people have been encouraged not to make those payments. However, I think we are going to see some sectoral and regional differences coming as a result of this policy.

Abramowitz - 22:31

When you talk about how the bond market could be kept afloat perhaps more than the loan markets and certain segments, which investors or which actors, do you think will absorb the bulk of the losses, as there are insolvencies and as recoveries are lower?

King

That's a good question because the whole effect is to disclose it and postpone it to the point where people almost forget whose taken the loss rather than having losses in repricing. One historical episode that comes to mind is in Japan when the bubble burst in 1990; we didn't get the pickup in bankruptcies until 1997/98 when the banks were recapitalized and almost allowed to take the loss. I'm still though generally inclined to think that it would be more in the banks which are provisioning a lot. As things stand, maybe likewise some of the CLO portfolios. Again the smaller companies, and some segments of the high yield bond market. What's really happening is this strong segmentation at the moment. And the big difference in risk premium between the areas receiving direct support and those that aren't.

Video Link: https://youtu.be/4rr2HwpWGnk