The “Restructuring Deficit”

Financial Repression is being implemented by Monetary and Financial Authorities in many developed economies. The specific measures range from overt manipulation of traded markets, acquisition of toxic assets at off-market prices, an aversion to implementing needed restructuring of bankrupt entities, through to indirect forms of intervention such as we are witness to in Canada. The short term consequences of these types of policies include restraining economic growth, employment and productivity. Longer term consequences include inducing a greater predisposition towards inflationary policies by the monetary authorities, loss of competitiveness, moral hazard, below potential GDP growth and depressed rates of capital formation.

The Canadian Experience

In Canada so far our Central Authorities have refrained from overtly intervening in markets as noted above. That job has been left to the Crown Corporations. The Economic Action Plan announced in 2008 provided the Crowns with additional capital and a mandate to use that capital to support Small and Medium sized businesses in Canada (SMEs). Since then the Crowns have made no secret of their extended mandate.

Thus, one need not look far to find evidence of this “stealth bailout”. In Canada we have seen rapid increases in personal bankruptcies that mirror the weakness in the jobs picture and the cost-cutting efforts of many firms desperate to remain in business. Also, the number of personal bankruptcies has escalated rapidly, consistent with the scale of job losses in the early stages of the GFC. However, on the business side of the coin, the situation in Canada reflects the perverse nature of this stealth bailout. This is the fact that since the onset of the GFC the business bankruptcy statistics are not telling a tale of undue financial stress. In fact, the latest twenty four months of data show that the incidence of corporate failures in Canada has actually gone down! The data show that there were 38% fewer bankruptcies coast-to-coast in the year to October 2011 than  2007 just prior to the GFC.

The “Pig in the Python”

At the same time according to the chart, at the peak in 2010 there waa an almost foufold increase in Gross Impaired Loans (GIL) in Canada. In 2011 the GIL numbers were still almost three times higher than in 2007 and prior to the GFC. Yet, corporate bankruptcies have gone down! Moreover, if you speak to them most insolvency professionals report that business has been at it lowest ebb that they have seen over their entire careers! A number of Canadian restructuring firms have sharply cut back staff, gone out of business or have otherwise greatly curtailed their operations. Per the above-noted chart the chief cause is that the banks are not reprocessing their NPL assets in a manner consistent with past cycles and have instead been exercising extreme forbearance.

The bottom line is the fact that a large volume of restructuring that would have normally been expected to occur on the wake of the Global Financial Crisis (GFC) in 2008/2009 has simply not occurred.

Quantitative Analysis

The statistical records on corporate failures in Canada that have been maintained by the Superintendant of Bankruptcy extend back almost sixty years. The behavior of this time-series is akin to that of a step function. Historically there has always been a sharp increase in the incidence of corporate failure in the immediate aftermath of an economic slowdown or recession. This relationship has held up through numerous cycles up to, but not including the GFC. And, in looking at past cycles, the increase in the failure rates on a twelve month moving average basis was at times as high as 60% peak to trough.

The past decade has seen three distinct phases of restructuring activity in Canada. Between 2000-2003 in the wake of the Telecoms, Internet and Media bust, Canadian banks resorted to bulk sales to divest themselves of unwanted assets and distressed files. Two of the more motivated banks in this regard were CIBC and the TD. Then, between 2004-2007 the bulk of off-strategy and distressed files  were pieced out by way of bilateral loan sales to leveraged loan funds that were relatively credit and price insensitive. Both of these periods saw significant levels of activity where banks were actively repositioning credit risk in their portfolios. Following that and since 2008, and up to the present, there has been very little activity despite a sharp run up in Gross Impaired Loans balances. There has been a corresponding lack of activity in business failures and active restructuring of loan files.

To examine the history further we have used three quantitative approaches to estimate a possible shortfall in the number of business failures that have occurred since the GFC:

The first test we ran tested the null hypothesis that the distribution of failures before the GFC had the same statistical properties as the distribution of failure events following the GFC. The results here show that it is not possible to reject the hypothesis that the distributions are different. This provides some statistical support for the contention that we are in a different behavioral phase with bankruptcies and corporate restructuring in Canada now relative to what went on before the GFC.

We then used two other methods to drag some more information out of the data set. The objective of both tests was to try and determine if the level of business failures that we have experienced in Canada since the GFC is “unusually low” and is so by how much. In summary this exercise suggests that there is at present a “restructuring deficit” of between some 6,000 and 13,000 businesses that could have been expected to have gone bust in the last three years but did not (This translates into between approximately one-half to one percent of all SME businesses in Canada). Translating those figures into potential monetary exposures Recovery Partners estimates that there are at least $20 to $30 billion of loan-related charge offs and or restructuring candidates that are bottled up on chartered bank balance sheets and elsewhere.

Zombie finance works only once. At the time this strategy was implemented the expectation was that the significant stimulus that was pumped into the economy would have resulted in a fairly rapid pace of recovery. In turn this would have refloated the businesses that were underwater allowing them to return to profitability and pay down their debt. This clearly has not happened. And, it is unlikely that the old zombies will be able to pull off another rescue financing particularly if the economy continues to grind along at a low rate of expansion or if it falters and maybe another downturn works its way into the mix.

A Rising Default Environment

A number of macro-economic factors affecting credit markets worldwide, including in Canada, suggest that all credit markets are entering a rising default rate environment. Both US and Canadian consumers are beginning to exhibit substantial signs of spending fatigue simultaneously with a significant, and accelerating, renewed softening of residential real estate markets in the US — the source of a substantial portion of consumer spending and employment growth in the last decade. Moreover the widening crisis in the Euro zone has already knocked EU growth for a loop as a recession is now expected there. The inevitable contagion will likely lead to confidence problems in North America as well threatening a more protracted slowdown here as well.

Therefore, for the banks, time is running short. Further cracks are appearing in the banking system and the economy and the authorities cannot stop them from spreading. In fact our views on the Stress Tests reflect the opinion that the problems in the banking system are far from having been properly resolved. In the US, in aggregate, banks remain significantly undercapitalized. Moreover, numerous US Banks that have earlier qualified for TARP funds now have more toxic (Level 3) assets on their books than before the financial crisis began. Other areas of concern include credit cards, commercial mortgages, and of course the fact that anecdotal and other evidence continues to reflect an anemic US economy whose consumers are tapped out and who have either fallen into unemployment or under-employment in vast numbers, where a substantial portion of the housing stock is under water, and whose Government is in a deepening fiscal hole.

In Canada, the situation may be even riper for a downturn in the credit cycle, especially in the export sector. The Canadian dollar has appreciated against the US dollar by more than 40% substantially eroding profit margins for Canadian exporters. For many of the banks as well, it is a case of “they do not know what they do not know”. Quite simply this means, that because of the distortions caused by zero interest rates, the lax forbearance practices and easements in lending covenants and loan servicing, many banks cannot today reliably identify all of the zombies and at-risk obligors in their portfolios. There is thus a substantial recognition lag built into the required solution to this problem.

Should the economy slow from here or enter a recession, institutions that hold large quantities of bad or deteriorating credits that have hitherto been slow in dealing with these exposures will find themselves competing against each other to unload or otherwise cope with these problems. Moreover, to existing exposures we have to add the new zombies that will have gone to ground because of continued weakness in overall activity.

This article is an abridgment of a longer research piece written by Alex Jurshevski, Managing Partner of Recovery Partners with research assistance from David R Fine, Director Credit Asset Management at Recovery Partners and appears in the January 2012 edition of Canadian Hedgewatch

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