Bankruptcies: The Next Wave

Credit markets have already improved and the economy may be on the road to recovery, but that won't prevent a new run of corporate bankruptcies in the next year

By Ben Steverman

Recent earnings reports show companies are slashing costs, paying off debt, and stockpiling cash. Meanwhile, economists see signs the economy is slowly improving.

Unfortunately, none of that could prevent a wave of bankruptcies by firms walloped by the recession and credit crisis.

That's the prediction of experts on bankruptcy, who say too many firms are loaded up with too much debt to survive the next year without defaulting on their debt obligations and filing for bankruptcy protection.

Standard & Poor's, for example, predicts the default rate for speculative-grade (i.e., junk-rated) companies to hit an all-time high of 14.3%—but not until the first quarter of 2010. The default rate was 9.25% last month, and just 0.79% back in November 2007. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP).)

Corporate Debt Pileup

Corporate credit conditions could worsen despite the fact that investors and lenders have already been inundated by bankruptcy filings. So far in 2009, according to BankruptcyData.com, 139 U.S. firms—with assets of $386.2 billion—have filed for bankruptcy protection or liquidation. In all of 2008, 138 firms with assets of $1.16 trillion filed for bankruptcy.

In 2007, by contrast, bankruptcy was filed by 78 firms with assets of just $70.5 billion.

The reason bankruptcies could get worse before they get better? "There is still a lot of debt on the balance sheets of Corporate America," says Craig Barbarosh, an attorney at Pillsbury Winthrop Shaw Pittman and expert on bankruptcies and restructuring.

Until 2007, banks and credit investors freely lent out money. Now, those loans will be coming due at a time when the economy is still weak and access to credit is restricted.

Not that conditions haven't improved somewhat. The rally in the stock market since March has coincided with an improvement in credit markets, making it easier for some companies to borrow money.

Scant Access to Credit

However, credit is only available to stronger, creditworthy firms—and even those companies find the debt more expensive than usual, says Jeffrey Manning, managing director and head of the special situations practice at Trenwith Securities.

Despite the improvement in credit markets, "it's very tough to get credit right now," he says. For firms seen as troubled, it's nearly impossible.

"We really have not seen a whole lot of improvement," says Diane Vazza, managing director at Standard & Poor's.

If there is good news, she says, it is that the number of firms with serious credit problems isn't increasing anymore.

In a July 27 report, S&P listed 285 companies as "weakest links," firms most in danger of defaulting on credit obligations. That's down from 290 in June and a record of 300 in April. (Firms have left S&P's danger list since April mostly because they have actually defaulted—not because they improved, Vazza notes.)

Office Depot Rebounds

Whether they're on the verge of bankruptcy or just in a financially weakened condition, companies have scrambled to improve their balance sheets. And, in recent months, some firms have undoubtedly made progress.

One example is Office Depot (ODP). In a July 28 earnings release, the retailer showed its net debt had fallen to $173 million, from $756 million a year ago. "Cash flow and liquidity are key focal points for us in these challenging times," Office Depot Chairman and Chief Executive Steve Odland told analysts.

Based on the results, Deutsche Bank (DB) analyst Mike Baker concluded bankruptcy is "no longer in the discussion" for Office Depot. "We applaud management's ability to bring the company back from the brink," he wrote in a July 28 note.

However, Office Depot is in a much better situation than many other firms still burdened by heavy debt loads and weak business conditions.

Most Vulnerable Industries

The most vulnerable industries are media and entertainment, forest products and building materials, and retail and restaurants, according to S&P.

Many commercial real estate firms are also facing a bleak future, Barbarosh notes, as rents fall, vacancies rise, and debts come due. "Loans are maturing, and there's no ability to refinance because underlying assets are worth less than the debt," he says.

S&P's Vazza notes that defaults typically peak six to nine months after the economy hits bottom. Even if the economy hits bottom this quarter—as S&P predicts—the recovery will be especially weak. So credit problems could persist well into 2010, Vazza says.

The irony is that a record number of troubled firms could tumble into bankruptcy next year, at the same time that the economy and credit markets start showing major signs of improvement.

Steverman is a reporter for BusinessWeek's Investing channel.

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