Why so many bankruptcies?

0:05Pushkin. Bankruptcies are up in America. And I am not talking about moral bankruptcy, nor am I even talking about personal bankruptcy. I'm talking about corporate bankruptcy. 2024, the highest number of corporate bankruptcy filings since 2010, according to S &P. Today on the show, is America teetering on the edge of economic disaster? This is Unhedged, the markets and finance podcast from the Financial Times and Pushkin. I'm Rob Armstrong, coming to you from the frostbitten and frigid headquarters of Unhedged here in New York. There's icicles hanging from the ceilings. We can see our breath. A polar bear is tapping at the window.

1:02I'm joined by Aidan Reiter, who's wearing five scarves on the other side of the table. Hello. It's almost hard to talk over all these scarves. Okay. What's weird about this to me, Aidan, is that you wrote about this increase in bankruptcies the other day. But what we've mostly been working on recently is increasing evidence that the US economy, rather than being too weak or starting to wobble, is concerningly strong. Yeah, we've had a couple of stronger than hoped inflation readings. We had a Fed meeting that showed that is very cautious about what inflation might be in the next year. Sure. And cautious about other things, too, but we don't need to talk about that.

1:49Yeah. And we've had a couple other data readings that are supportive of a stronger economy. Right. EMIs are warming up. EMIs are warming up. Surveys of business purchasing managers, they're saying new orders are rising. There's been an uptick, especially on the manufacturing side, which we haven't seen in a long time. Yeah, job openings are up, suggesting we're entering into a slightly tighter labor market. The bond market's kind of worried about all this, or that's one interpretation of what the bond market is doing. Yeah, yields on 10-year treasuries are way up. They're at their highest level since last April.

2:21They're at 4.7%. Right, so that means bond prices are falling, and that's consistent with a Fed that stays a little tighter, and et cetera, et cetera, and people preferring to be in equities maybe. It could mean all kinds of things. And yet, amidst all this slight concern about an overheating economy, we have this bankruptcy number, which is strange. It's a little up from last year. I think it's what, 8 % up? 8%, yes. So, you know, things have not been amazing for a while, but they're getting worse, arguably, or hey, they have been getting worse for some of these companies. I mean, looking at this, at the time series of that S &P provides here, the natural interpretation is something like this.

3:02You had high bankruptcies still in 2010 because we're still operating in the shadow of the great financial crisis. But then the fact that the Fed has basically pushed rates way down kicks in. And you have low bankruptcies every year up until now simply because rates are so low. That is an interpretation. Yeah, yeah, an interpretation. And bankruptcies were basically nothing in 21 and 2022 because it was basically illegal to go bankrupt at that time. I'm pumped with money, pumped with PPP to stop you from getting bankrupt. And so now it's like this is just your turn to normalcy. And so I would guess that the companies that are going bankrupt, the first guess would be they're the ones who mismanaged their debt.

3:45Rates are higher now. It is now possible to go bankrupt again because interest rates have risen. That is a great guess about what might be happening. But we took a closer look and it might not really be the answer. I love how great guess is just a euphemism for you are wrong. Well, you're as wrong as far as we can tell. So we looked at the 10 biggest bankruptcies and called out a couple names. So of those 10 biggest bankruptcies, five were private, so we didn't look at those. One was just this, essentially an asbestos legal claim holding company that was meant to go bankrupt on behalf of Johnson & Johnson.

4:21Think what you want about that. That's enough for another podcast. And then four were these relatively big names. Then we added in two other big names that we thought were going to try. So what are the companies we're talking about here? So we're talking about Big Lots, which is a home goods store and discount seller. Container maker Tupperware of 1950s fame. Fabric seller Joanne Stores. We've got Party City, where everybody loves to go buy Halloween costumes and other fun party supplies. Discount Air Carrier Spirit Airlines, the butt of every SNL joke. Franchise Group, which is the owner of retail chains, the Vitamin Chop, Pet Supplies Plus, and a couple other franchise chains.

4:58So the big ones, it's interesting. There's definitely a pattern there, but I have a very important question for you before we even get to that. Have you ever been into a party city? Many times. What kind of glorious things do I get in a party city? And why have you been into party city many times? I grew up in the suburbs of Connecticut. What else is there to do besides go to party city? Yeah, growing up, it's where you get your balloons. It's where you get your tinsel. It's where you get masks or at least before Amazon. Yes, yes. Now, that's kind of the point here, isn't it? But is it true that these companies, just we did a small sample of the biggest ones, but of the ones you looked at, was debt mismanagement, did they have a lot of floating rate debt?

5:41Did they pile on too much debt in a take private or something like, is debt the problem here? It's part of the problem, but it's not the problem. Right. So we've talked about before, a lot of people thought that, you know, small cap stocks, right, small companies that theoretically have more floating rate debt were set to have this renaissance when rates came down. And they've had a renaissance for other reasons, but it wasn't because of that. Because if you look at their interest expense, their interest expenses haven't risen because floating rate debt has not been that punishing to them. Yes.

6:07This is kind of a similar picture. Right. If you look at the debt profiles of all these companies, some of them really took on debt for other reasons, right? Spirit Airlines took on a whole heap of cash. Just debt, just to stay alive. Just to stay alive, right? And as it's a franchise group had some private merger, complicated talks going on to put them with debt. But for the most part, if you look at the interest expense of these companies, Spirit was actually able to shrink its payments over time. Joanne and Party City kept them mostly in check. And Tupperware even saw their interest payments.

6:36So Tupperware even shrunk them. So it's not high rates and floating rate debt that sunk these companies. It's the other side. It's the other side. Well, they did take on a lot of debt, right? We should note that Big Lots, Spirit, and Franchise piled on debt for other reasons. Yes. But it's the other side of the equation. It's their earnings completely plummeted. Yes. Right? So if you look at their net debt to earnings ratio, right, which is a pretty good indicator of whether or not these are - Yeah. It's the standard way to think about how indebted a company is. Yeah. So most of them climbed from one to two up to past six, which is the threshold at which lenders go running for the house.

7:11Earnings. Debt six times earnings. Yeah, debt six times earnings, right? Yeah. So they've all kind of crept above that threshold in this. Because their earnings were falling, not so much because the debt was rising. Yes. And interest expenses, for the most part, weren't ballooning. So it was more an earnings picture. That being said, some did see a crazy jump, like Spirit saw an insane jump to 56 debt to earnings ratio. But even they brought it back down. Yeah. Yeah. So it's interesting that, you know, on first glance, we have this group of companies that leads the bankruptcy list and they're very retail kind of.

7:47And they had an earnings crisis as well as just even perhaps even more so than a debt crisis. Yeah. So the point is, it's not that, you know, high rates in the economy and the Fed keeping high rates is finally enacting pain. Yeah. It's enacted pain for a lot of companies, but that's not the cause, at least for these companies we looked at. Yes, they have a lot of debt, but it's not the floating rates. It's the earnings came down. And it's because these companies, and again, we only looked at six, are kind of dinosaurs already. Yes. Right? Franchise group. In the age of Amazon, everybody's buying stuff online.

8:16Yes. Who's going into Joanne to buy their yarn? Yes. Who's going into Party City to buy their balloons? Yes. And these companies just had a lot of trouble transitioning into the online marketplace or creating a real reason people come to their stores. Tupperware is a specially bizarre example. Not only have they not been able to transition to online, they've kept their peer-to-peer selling model, which just has not been able to keep up with the way that we all buy things today. Spirit's a whole other case, right? There were some issues with their planes. Airlines are a very tough industry to be in to begin with.

8:47So there's always that. They kind of got butted out by other cheap competitors. And then there was this failed merger with JetBlue that really sunk them. The picture you've just sketched suggests that rather than thinking, gosh, bankruptcies are up, the U.S. economy is weaker than you would otherwise think. This looks to me like it supports a theory called the K-shaped recovery. Definitely. That we have a strong economy overall, but that's one leg of the K, the one that points up. But then there is a bottom leg of the K where there are certain companies, industries, individuals who are more vulnerable and are having more trouble.

9:28Yeah. All of these companies have had trouble, or most of these companies have had trouble transitioning to the online economy. But if you look at them, the thing that really unites them for the most part is they are discount stores, Big Lots, Joanne, Pet Supplies Plus, right? These are discount stores, theoretically in quote unquote middle America or in places where people are looking for those deals. Well, I can give you another painful example. I thought this year was going to be worse economically than it's turned out to be. And one of my stock picks in the FT stock picking contest was Dollar Tree.

10:00I think it was Dollar General. Dollar General. It was one of the two. Anyway, I was thinking, here's a company that's doing a turnaround. If there's economic stress, you know, maybe they'll turn it around anyway. that whole industry has just been crushed. Their core customer is just spending less. They're seeing, you know, their big complaint in the dollar stores is that the average basket is getting cheaper. The average ticket is lower. So people are still coming into the dollar stores, but their core customer is spending less every time they come into the store. And even in the range of a dollar store, they're buying the cheaper items, the less profitable items.

10:38So that's consistent with the tale you just told about your party cities and your big lots and your, what's the pet one? Franchise group, which owns Pet Supplies Plus and the vitamin shop. Pet Supplies Plus. You go into Costco and it's just like, why would you ever go to anywhere else? You get the gazillion pound bag of dog food and the price is unbelievable. And yeah, you know, it's just like the world of retail has changed. It's not just Amazon, it's Walmart and Costco. Absolutely. You know, the bigger stores, the big discounters. Yeah. So, I mean, to the extent this suggests there is a case-shaped recovery, it's real.

11:10We should caveat a couple things though. First of all, these companies are not necessarily going anywhere, right? Yes. Bankruptcy doesn't mean you disappear. It can proceed disappearing. Liquidation. Yes. But for the most part, this is just them renegotiating debts, maybe being sold to new buyers. Some of them kind of like entered in and out of bankruptcy multiple times the past couple years. Party City is a good example there. So we might still see these franchises. They're just going to be different businesses. We should also note that there's something called creative destruction, right? People think post 2010, post some crisis, you want to see some of these companies go belly up because they were not competitive enough.

11:46So to some people, this is actually a sign of a healthy economy that's working well. Indeed, you might look back at the last 10 or 15 years and say the problem was bankruptcies were too low. They were certainly too low in 21 and 22. And you might look through the whole like 2011 to 2022 period and say, the US economy is not churning enough. There's not enough creative destruction. Yeah. And people have said that about Europe as well, right? Europe has much more support, especially during COVID for employees. They do that through via employment vehicles. So essentially, you have these quote unquote zombie companies.

12:19And is that why Europe and US are having this big gap? Yeah. I mean, it's an argument that's out there, but we would say that the US also hasn't been shuttering companies up until now. Yes. I guess we are also seeing evidence of the K-shaped economy hypothesis on the household side. You and I have talked a lot about consumer credit default rates. I'm looking here at the household debt report, which is an excellent report everybody should read, released by the New York Federal Reserve. And looking at transition to 90 days delinquent, 90 days delinquent is when you're really delinquent, not alone, right?

12:54That's one month, you know, they lay a slide. Getting to default. You're getting towards default. And you look at the percentage of credit card balances that are entering 90-day delinquency, and, you know, they're up above 10 % now. They were closer to six or five. There's been a pretty steep increase in the line. That's credit cards. And on the auto loan side, among young people, especially, this is our kind of favorite stat, is like young people are really sliding into default at sharply higher rates on their auto loans. Yes. But, you know, we should note that it has been a bad economy, right?

13:31That was... Yeah. Things were sliding up a lot in the run up to the first Fed cut. Sure. Since then, those numbers have gotten better for almost every age group, right? Yes. 18 to 29, 30 to 39, younger, poorer households. The line looks like it's peaked and just begun to turn over in terms of transitions to delinquency. Yeah. So, you know, households, right, there has been this K-shaped economy, if you believe in that theory. There has been a lot more strain on lower income households, and that's shown in these numbers, but it's starting to turn the corner. And there actually was a very good piece from the Kansas Fed a couple weeks ago that made the point that, you know, banks put out these forecasts of the likelihood of people to default.

14:06And that number has kind of stayed the same level. These numbers are kind of the bank's own assessment of the amount of defaults they're going to see in their own credit portfolio. Yes, among already highly indebted borrowers. And even though the number had gone up a lot in the last two years, people defaulting are getting close to default, that number of how many people would default has actually stayed flat. Our expected default. And that has tended to be a leading indicator in the past. And it takes about 18 months. So it looks like now we're going to see things turning the curve, right? So just like the default rates among young people are coming down, it's expected that things will start stabilizing for people who are heavily indebted in the coming months.

14:46So we have pretty good evidence both on the corporate side and on the household side that there's a K-shaped recovery here. But there is also some evidence that for the bottom leg of that K, the weaker, that smaller but weaker part of the economy, things might be getting a little better. I think that's definitely fair. I mean, inflation is a part of the economy that specifically hurts lower income households because they spend more of their weekly bill on essentials, right? They can't get around spending more at the grocery store as opposed to it might take up less of a more wealthy person's budget and monthly spending.

15:22So if inflation ticks up again, they're going to continue to see problems. And to be honest, they're at a low point because over the last two years, they had been squeezed by inflation and had been squeezed by low rates. But the point is we might be starting to turn the corner, especially if the U.S. economy is heating up and we don't reenter into inflation. Well, that sounds almost optimistic. Good for a curmudgeonly pair like us. We'll be right back with Long and Short.

15:55Welcome back. This is Long and Short. that portion of the show where we go long things we like and short things that we do not like. Aidan, are you long or short something today? I am long ceramics. The dishwasher at Unhedge HQ is broken. So us and all of our colleagues are drinking out of paper cups. And I just, not having a ceramic mug makes me so sad that I am now really appreciative of my ceramics and I'm long the mug. And it's also a general point. And any time in modern life where you lose one of the mechanical basics, you really realize how awesome they are. Like, what's better than a dishwasher?

16:32Yeah. Oh, my God. That thing rules. Yeah. Also, like, I think there's something so demoralizing about sitting in your office and drinking out of a paper cup. Like, a paper cup is for being on the go and nothing else. Yeah, it's true. Well, I am long something, too. I am long the Greenland debate. I mean, my initial reaction to the president saying he wanted to buy Greenland from Denmark was to laugh it off. But reading about it, including in excellent articles in our newspaper, has really informed me about the geopolitics of the Arctic. I look forward to a robust debate about the future of the far north.

17:12Well, I hope like the Arctic, it says a cold debate because I might be drafted into that war. You're going to love Greenland, man, when you're fighting the Danes. Listeners, I'll be back in your feed on Tuesday. If Aidan hasn't been drafted, he might be too. Until then, stay sharp out there. Unhedged is produced by Jake Harper and edited by Bryant Erstat. Our executive producer is Jacob Goldstein. We had additional help from Topher Forhez. Cheryl Brumley is the FT's global head of audio. Special thanks to Laura Clark, Alistair Mackey, Greta Cohn, and Natalie Sadler. FT Premium subscribers can get the Unhedged newsletter for free.

17:51A 30-day free trial is available to everyone else. Just go to ft.com slash unhedged offer. I'm Rob Armstrong. Thanks for listening.

18:17Thank you.