A Wave of Bankruptcies and Foreclosures Appears to be Building
A perfect storm of COVID-related economic issues mixed with inflation and a stay-at-home workforce is bearing down on small businesses and real estate investors. Don’t wait to take evasive action.
Economists and professionals in the restructuring sector of business and real estate have been anticipating a distressed economy for the past 18 months. Thus far they have been wrong.
The public is just plain confused. Many people today don’t trust their politicians, their news sources and, surprisingly, not even their health care providers and professionals. This lack of trust, coupled with the pandemic-driven mandated way in which many employees work remotely, has caused many people to reassess their lives and the location from which they are willing to provide their services.
Many employees holding mid-and upper-level jobs will opt to permanently work remotely and never return to the office. This shift in the way people will work in the future will have a profound effect on many aspects of our economy, including the ability of landlords to keep commercial spaces leased.
Factors Influencing the Current Economy
COVID-19, the Delta, Omicron variants and now the highly contagious BA.2 variant have caused millions of workers to be unavailable for work, either remotely or otherwise. This has created a serious supply and distribution chain disruption. This problem is caused in part by manufacturers not being able to supply component products due to worker disruptions in factories. Add to this supply shortage the fact that personnel disruption in the transportation and delivery of products caused by COVID (i.e., the shortage of truck drivers) and we can clearly see the full picture of the disruption in the supply chain.
The threat of a substantial new round of tariffs, embargoes and other economic sanctions based on the political climate creates further risks of the U.S. becoming a distressed economy. In addition, there is a looming threat of high inflation. On the positive side, until recently the stock market and overall economy were generally clicking along at a solid and positive pace. The stock market doesn’t always accurately represent what is really going on in the economy, but recent market volatility may be a harbinger of troubled times ahead.
Will the accumulation of these factors ultimately cause the predicted distressed economy? No one knows for sure, but in analyzing the situation it may be instructive to look at the issues that have prevented the anticipated downturn.
Banks and Banking
Since the pandemic began, regulators have not been pressuring banks to take action with respect to defaulted loans. Historically, banks have been willing to “kick the can down the road” with respect to defaulted loans if they could do so without significantly impairing the accounting value of the loans with respect to the banks’ capital requirements. Regulators’ current attitudes have allowed the banks to do just this.
While the regulators’ laissez-faire attitude has had a definite positive short-term effect on the economy, at some point the regulators know that the effect of their actions will cause banks to have misleading financial statements.
It is not likely that regulators’ behaviors will change before the midterm elections later this year. At some point, however, they will have to stop allowing banks to avoid classifying loans. Otherwise, they risk allowing the banking system to continue to mispresent the value of its loan assets, with all the risks of that situation impacting the creditability and stability of the banking system.
It is my view that when the bank regulators change their position with respect to their treatment of defaulted loans, an anticipated tsunami of real estate foreclosures and bankruptcies will be upon us.
Additional Factors to Watch
Interest rates have historically had a substantial impact on the economy, especially the real estate sector.
The Feds have kept interest rates at almost zero to support the economy. Now, however, the specter of high inflation will almost certainly bring an end to near-zero interest rates. Annual inflation during 2022 is projected to be close to 7%. The Fed has already announced its intention to fight inflation by raising interest rates as early as in March. The issue is not whether interest rates will rise. Rather, it is by how much and when.
Rising interest rates hurt individuals in many ways:
- The most obvious is that they make housing less affordable. As interest rates rise fewer and fewer people will qualify to buy their own homes. Present homeowners with variable-rate mortgages will also be negatively impacted by interest rate increases.
- Rising interest rates also negatively impact the profits of businesses. This will impact the stock market, and therefore the value of stocks in individual IRAs and 401(k)s.
- Major shifts in the way people work will result in winners and losers. Time will tell how this will play out, but it is certainly looking like the economy will be disrupted.
Pressures on Businesses Pile Up
The re-emergence of COVID in the form of the current variants has all but destroyed the timetable for society’s return to normalcy. There is no reliable way to predict the effect of this re-emergence on the psyche of the country. It is predictable, however, that this re-emergence will negatively impact the economy, and will further delay a return to normalcy.
In fact, it is likely that normalcy, as it existed pre-pandemic, will never fully return. Trends like the shift of consumers primarily conducting their shopping online will have a negative effect on brick-and-mortar retail sales. The need for retail space seems poised to continue to decline even more than it has already. This problem has been accelerated by the pandemic.
Owners of shopping centers and commercial buildings are girding for the rash of vacancies that are most assuredly on the horizon. Individuals would be well advised to assume inflation and higher interest rates are on the near horizon and should act in any way possible to mitigate the harm to them from the looming dual threat. It is uncertain how federal, state, and local governments will react to the situation.
Uncertainty is the enemy of business, and it is clear we are facing uncertain, unpredictable times. The public’s general perception of all of this is yet to be seen. There is much distrust by the people of our nation. These factors will combine to create a perfect storm for companies and real estate investors to experience increasingly distressed financial times.
Steps to Consider
The best advice we can offer is for entities to deal with their distressed assets early on.
- For homeowners, interest rates will almost certainly increase in the near future. If a homeowner can refinance his or her mortgage to take advantage of the current low interest rates, that course of action should be considered.
- For consumers, accelerating the timing of any major purchases will make sense since the looming inflation will make the dollar worth less and less and make the effective cost of an item more expensive as time passes.
- Individuals should also consider exiting the stock market or minimizing their stock portfolios as soon as possible. Conversion of stock to cash is not a good strategy during a time when the value of the dollar will steadily decline. Conventional wisdom dictates that investment in precious metals, such as gold and silver, is a safe harbor. Thus, selling stock and buying gold and silver makes sense.
- Business owners should analyze their businesses based on the assumption that the near future will bring high inflation, high interest rates and a continuation of supply chain disruption. It is prudent to take steps to restructure the business in a way that will mitigate the damages if those future assumptions come to pass.
The general public will be looking at inflation and rising interest rates and will react accordingly. The earlier people and businesses accept and respond to these changes, and react appropriately, the more likely it is that Chapter 11 bankruptcies can be avoided. This not only increases the chances that companies can resolve their financial issues without resorting to bankruptcy, it often reduces the need for employee layoffs.
About the Author
Founder and President, Distressed Capital Resources LLP
William N. Lobel is the Founder and President of Distressed Capital Resources LLC, a company that has brought together virtually every resource available to assist borrowers with financially distressed real estate or businesses, with the goal of maximizing a borrower's leverage and options in order to successfully resolve that borrower's financial issues.