The Restructuring Report

Although they disagree about the severity, economists and market watchers generally agree that the U.S. economy is headed for a slow-down. According to data from the Federal Reserve Bank in St. Louis, industrial production and retail sales are at all-time highs, exceeding levels seen before the 2008 recession. Unemployment rates are at the lowest levels since November 2000. So why the gloomy predictions for 2019 and beyond? Historically, retail sales, industrial production and employment are at their peaks right before a recession. This is one of the reasons that predicting the timing of a slow-down or downturn is so difficult – the economic picture often looks strong in the months immediately preceding. Moreover, there are other important factors in play. The Federal Reserve has been raising interest rates and shrinking its balance sheet at a recent rate of approximately $50 billion a month. In addition, the halt in the march toward globalization, such as the U.S. tariffs on China, China’s corresponding response and Brexit, have negative implications on the U.S. and global economies.

Despite some similarities to the economic picture in the months leading up to the 2008 recession, a 2019 slow-down or downturn will likely look much different and so will the processes to recovery. Analysts and economists agree that the 2008 recession was largely driven by a housing bubble, underscored by subprime loans and record levels of household debt. Although 2019 consumer debt is at a level similar to 2008 (albeit a smaller percentage of GDP), the composition of the debt is markedly different. Consumer debt in 2018 was primarily comprised of mortgage debt, whereas, consumer debt in 2019 is primarily comprised of credit card, auto and student loan debt.

More than 90 percent of the $1.5 trillion in student loan debt is owed to the U.S. government. Significant defaults on student loan debt would lead to a shrinking in the supply of available student loan funds, pushing more potential students to private lenders, who will in turn lend under far less generous terms. Moreover, student loans are not subject to discharge in bankruptcy, except in rare circumstances, reducing the prospect that individuals can utilize the bankruptcy process to obtain a fresh start, as was often done with defaulted mortgage loans. This will likely have far-reaching impacts on the U.S. economy, including negative impacts on productivity. In addition, credit card loan losses, while limited, are rising, which indicates that consumers are facing growing challenges in paying down their loans despite record-low unemployment levels. The increase in credit card losses is causing lenders to raise their reserves and tighten the credit market by lowering credit limits for subprime consumers and restricting car loan underwriting. Given the U.S. consumer makes up approximately two-thirds of the U.S. economy, these are signs of potential trouble ahead.

Another difference from the period before the Great Recession is that the amount of corporate debt has increased substantially, doubling from approximately $30 trillion to now more than $60 trillion, with this growth occurring in both developed and under-developed economies. The corporate debt amounts represent approximately 90 percent of global GDP. In the U.S., the share of corporate debt as a percentage of GDP has exceeded the levels in 2008. This growth in corporate debt has been increasingly funded by unregulated financial institutions. Moreover, the corporate debt has been increasingly used to repurchase shares instead of investing in research and development or fixed assets, both of which would have had a more positive impact on the economy as a whole when compared to debt repurchase plans.

The U.S. government stepped in and bailed out the financial institutions that played a large role in the 2008 recession. China similarly bolstered its economy and the world economy by a significant increase in debt. The U.S. government, and other governments like China, will not be in the same position to rescue individual corporations should predictions about a slow-down or recession prove prescient. Indeed, the U.S. government debt as a share of GDP has risen from 40 percent in 2011 (following much of the economic stimulus) to now more than 50 percent, and in the face of a growing economy. As a result, the recovery may need to come instead from private markets, potentially those many unregulated financial institutions that hold an increasing share of corporate debt.

These private institutions are not subject to the same regulations regarding debt defaults as traditional banks. So it is fair to question whether these unregulated financial institutions may be able to withstand numerous defaults within their own portfolios. They are also more likely to pursue nontraditional approaches to collection. Increasingly, these private lenders appear to be utilizing nontraditional insolvency processes to realize value. For example, private holders of corporate debt are more likely to foreclose on and then operate a business, or appoint an assignee or receiver to undertake that process, as compared to an immediate sale to an independent third-party buyer or conditioning future advances on a Chapter 11 bankruptcy filing and 363 sale. Moreover, an increasing share of corporate loans either are not personally guaranteed or subject to “limited” guarantees that are triggered, such as in the event of a bankruptcy filing. Thus, there are not the same motivations that led many companies to seek bankruptcy protection in 2008 and the years that followed.

It appears that bankruptcy levels, for both corporations and individuals, will likely not return to those experienced in the years following the 2008 recession. Instead, the growth in any insolvency processes, particularly for corporations, will likely come in the form of out-of-court restructurings, receiverships or assignments for the benefits of creditors.