Four Predictions for Bankruptcy in the Wake of COVID-19

Research

Robbie Li
April 9, 2020
Research

Despite the unprecedented nature of the COVID-19 crisis, this is not the first time the market has seen a black swan event. From the 2000 dot-com crash to the 2008 financial meltdown, recent history offers us lessons on how the US economy may restructure in the near future. 

  • If historical trends hold true, an overlay of unemployment data and bankruptcy filings suggests that commercial bankruptcies are on the rise. [1]
  • With a likely shortage of credit caused by COVID-19, highly leveraged businesses that otherwise hold a lot of potential may file for bankruptcy. [2]
  • Companies with the most promise for turnaround will likely enter chapter 11 proceedings in an attempt to reorganize and cram down their existing creditors. [3]
  • Consequently, 2020 will likely see a sharp increase in chapter 11 filings from highly leveraged businesses with good fundamentals.

The four graphs below visually illustrate these findings.

Rising unemployment predicts increase in bankruptcy

The graph above illustrates the quarterly average of U-6 unemployment rate [4] and quarterly total of commercial bankruptcy filings from Q1 2000 to Q4 2019. Despite higher volatility, bankruptcy numbers correlate strongly with unemployment rate. 

The disruptions of COVID-19 have resulted in an alarming increase in unemployment.

  • U.S. Bureau of Labor Statistics reported 16.5 million [5] unemployment claims in 3 weeks, equivalent to 10% of the U.S. labor force. [6] 3.3 million unemployment claims were filed during the week ending on March 21; [7] 6.6 million new claims during the week ending on March 28; [8] 6.6 million additional claims during the week ending on April 6. [9] Each of these numbers surpassed the previous record of 695 thousand in October 1982. [10]
  • The Bureau also reported that March 2020 saw an increase of U-3 unemployment rate by 0.9 percentage points. It was the largest over-the-month increase in U-3 unemployment since January 1975. [11]
  • Economists at Federal Reserve Bank of St. Louis projected that the U-3 unemployment rate may be as high as 32% in the second quarter, [12] worse than the Great Depression, when the unemployment topped at 25% in May 1933. [13]

If the correlation between bankruptcy and unemployment continues to hold, current unemployment numbers suggest unprecedented levels of bankruptcy forthcoming in 2020. 


Credit to become increasingly unavailable

Credit availability decreases during economic recessions. During the 2008 recession, despite a close-to-zero federal funds rate, commercial banks increased their balance maintained with federal reserve banks by about 500%, meaning that it became much more difficult for businesses to get a loan when they needed it the most.  To a lesser extent, the same phenomenon happened during the 2001 recession. 

Despite the $2 trillion fiscal stimulus in 2020, [14] many businesses will still require commercial credit to tide themselves over. Now that the Federal Reserve has lowered the target federal funds rate to the range of 0 to 1/4 percent, [15] it is up to commercial banks to assess the risk of lending during a time of economic uncertainty.

If credit becomes unavailable, many businesses will likely have no choice but to declare bankruptcy. 

Businesses hope for turnaround through Chapter 11 bankruptcies

When businesses file under chapter 11 of the bankruptcy code,  debtors propose a plan of reorganization to keep its business alive and pay creditors over time. [16] The hope is that the debtor would access the otherwise unavailable credit, use that to restructure their business, and eventually turn it around to profit. However, the first step to revival is to get the court’s approval of the reorganization plan.

Historical data show that only a small number of all chapter 11 cases receive Bankruptcy Court confirmation. According to Curtis Smolar, General Counsel of Legalist, who has 20 years of experience in commercial litigation (including bankruptcy matters),

“Many of these cases are either dismissed or converted because creditors and debtors fail to come to agreement on reorganization terms. Companies that go into chapter 11 proceedings with stronger financial performance have a better shot at emerging from bankruptcy successfully reorganized.”

As businesses face credit constraints caused by COVID-19, many otherwise strong companies will likely file for chapter 11 proceedings. OneWeb, a satellite unicorn with a valuation  between $1B and $10B, entered a Chapter 11 bankruptcy proceeding on March 27. [17]

As firms like OneWeb with large secured and unsecured liabilities succumb to reorganization in the face of COVID-19, many more will follow suit.

Number of Chapter 11 filings likely to surge

The graph above compares the 1 year moving averages of S&P 500 quarterly returns and chapter 11 bankruptcy filings. Normally, the two series are negatively correlated and trending towards different directions, but the period between 2007 and 2010 was an exception. As S&P quarterly return rebounded, bankruptcy filings also increased. It is not until 2011 that the usually opposing trends returned to normal.

In other words, the impact of a recession on business bankruptcy can extend much longer than usual. If past trends hold true, then as COVID-19 drags the economy into a deep recession, bankruptcy filings will remain high even as the economy rebounds. 

“We think that business filings will see an uptick in April with an uptick in May and June.”

Says Amy Quackenboss, executive director at the American Bankruptcy Institute. [18]

If historical trends remain consistent, then we will likely see bankruptcy filings remain at a high level throughout 2020.  

Notes and References:

[1] Based on data from the US Bureau of Labor Statistics and American Bankruptcy Institute. See analysis in the article.

[2] Based on data from the Federal Reserve Bank of New York. See analysis in the article.

[3] This assumption is based on the different treatments companies receive when filing under different chapters of the U.S. Bankruptcy Code. A chapter 11 bankruptcy case, if confirmed by the court, provides the company with opportunities for debt restructuring.

[4] The U-6 rate includes workers that are unwillingly part-time, and therefore is a more robust measurement of economic well-being than the conventionally reported U-3 rate.

[5] Note that the number of 16.5 million is larger than the Department of Labor’s report of 7.1 million unemployed persons in March. This is due to different definitions of unemployment. The 7.1 million unemployed persons refer to the number of people in the labor force who are out of jobs and actively looking. The 16.5 million unemployed persons refer to the total number of people who have filed for unemployment insurance within the past three weeks. Not every worker who files an unemployment claim is considered part of the labor force. 

[6] The U.S. labor force is around 165 million, according to the US Bureau of Labor Statistics. <http://www.dlt.ri.gov/lmi/laus/us/usadj.htm> [Accessed 9 April 2020].

[7] Department of Labor, March 26 2020. Unemployment Insurance Weekly Claims. [online] Available at: <https://oui.doleta.gov/press/2020/032620.pdf> [Accessed 4 April 2020]. 

[8] Department of Labor, April 2 2020. Unemployment Insurance Weekly Claims. [online] Available at: <https://oui.doleta.gov/press/2020/040220.pdf> [Accessed 4 April 2020]. 

[9] Department of Labor, April 9 2020. Unemployment Insurance Weekly Claims. [online] Available at: <https://oui.doleta.gov/press/2020/040920.pdf> [Accessed 9 April 2020]. 

[10] Department of Labor, March 26 2020. Unemployment Insurance Weekly Claims. [online] Available at: <https://oui.doleta.gov/press/2020/032620.pdf> [Accessed 4 April 2020]. 

[11] Department of Labor, April 4 2020. Unemployment Situation Summary. [online] Available at: <https://www.bls.gov/news.release/empsit.nr0.htm> [Accessed 4 April 2020].  

[12] Miguel Faria e Castro, Back-of-the-Envelope Estimates of Next Quarter's Unemployment Rate St. Louis Fed (2020), https://www.stlouisfed.org/on-the-economy/2020/march/back-envelope-estimates-next-quarters-unemployment-rate (last visited Apr 4, 2020).

[13] National Bureau of Economic Research, Unemployment Rate for United States [M0892AUSM156SNBR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/M0892AUSM156SNBR, April 3, 2020.

[14] Families First Coronavirus Response Act, H.R. 6201, 116th Cong (2020). https://www.congress.gov/bill/116th-congress/house-bill/6201?q=%7B%22search%22%3A%5B%22families+first+coronavirus%22%5D%7D&r=1&s=5

[15] The Federal Reserve, 2020. Federal Reserve Issues FOMC Statement. [online] Available at: <https://www.federalreserve.gov/newsevents/pressreleases/monetary20200323a.htm> [Accessed 4 April 2020].

[16] Chapter 11 - Bankruptcy Basics, United States Courts, https://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-11-bankruptcy-basics (last visited Apr 4, 2020).

[17] OneWeb, OneWeb (2020), https://www.oneweb.world/media-center/oneweb-files-for-chapter-11-restructuring-to-execute-sale-process (last visited Apr 2, 2020).

[18] Andrew Keshner, 'It's really a question of when.' The coronavirus pandemic is about to spawn a surge in bankruptcies, experts say MarketWatch (2020), https://www.marketwatch.com/story/its-really-a-question-of-when-the-coronavirus-pandemic-is-about-to-spawn-a-surge-in-bankruptcies-experts-say-2020-04-02 (last visited Apr 4, 2020).